1 Industrial Organization - PowerPoint Presentation

1. 1Industrial Organizationand Strategic BehaviourIgor BaranovGraduate School of ManagementSt. Petersburg State UniversityFall 2009

2. 2Introduction WHAT is Industrial OrganizationStudy of How firms behave in marketsWhole range of business issuespricing decisionswhich new products to introducemerger decisionsmethods for attacking or defending marketsIndustrial Organization takes a Strategic view of how firms interact

3. 3 HOW Industrial Organization proceeds in practiceRely on the tools of game theoryfocuses on strategy and interactionConstruct models: abstractionswell established tradition in all scienceSimplification but gain the power of generalizationEmpirical Analysis—Use theory to form testable hypothesesfor entry deterring actionsexamine the impact of advertisingIndustrial Organization In Practice

4. 4 WHY do Industrial Organization?Long-standing concern with market powerSherman Antitrust Act (1890)Section 1: prohibits contracts, combinations and conspiracies “in restraint of trade”Section 2: makes illegal any attempt to monopolize a marketRegulation EconomicsTheory of Business StrategyMotivation for Industrial Organization Study

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

6. 6The Chicago SchoolGood as well as bad reasons for monopoly including superior skill and technologyPotential entry can discipline even a monopolyStructure is endogenous/causality difficult to determinePost-ChicagoGame Theoretic EmphasisCompetitive Discipline can FailCareful econometric testing to determine correct policy in actual casesADM (collusion)Toys R Us (exclusive dealing)American Airlines (predatory pricing)Merger wave (Maytag and Whirlpool)Chicago and Post-Chicago Frameworks

7. 7The New Industrial OrganizationThe “New Industrial Organization” is a blend of featurestheory in advance of policyrecognition of connection between market structure and firms’ behaviorContrast pricing behavior of:grain farmers at first point of salegas stations: Texaco, Mobil, Exxoncomputer manufacturerspharmaceuticals (proprietary vs. generics)

8. 8Contemporary Industrial OrganizationWHAT: The study of imperfect competition and strategic interactionHOW: Build on game theory foundationDerive empirically testable propositionsEconometric estimates of relations predicted by theoryWHY: Motivated largely by antitrust concernsAlso interest in private solutions to inefficient market outcomes

9. 9Basic Microeconomics

10. 10Efficiency and Market PerformanceContrast two polar casesperfect competitionmonopolyWhat is efficiency?no reallocation of the available resources makes one economic agent better off without making some other economic agent worse off

11. 11Perfect CompetitionFirms and consumers are price-takersFirm can sell as much as it likes at the ruling market pricedo not need many firmsdo need the idea that firms believe that their actions will not affect the market priceTherefore, marginal revenue equals priceTo maximize profit a firm of any type must equate marginal revenue with marginal costSo in perfect competition price equals marginal cost

12. 12The First Order Condition: MR = MCProfit is p(q) = R(q) - C(q)Profit maximization: dp/dq = 0This implies dR(q)/dq - dC(q)/dq = 0But dR(q)/dq = marginal revenue dC(q)/dq = marginal costSo profit maximization implies MR = MC

13. 13Perfect competition: an illustration$/unitQuantity$/unitQuantityD1S1QCACMCPCPC(b) The Industry(a) The FirmWith market demand D1and market supply S1equilibrium price is PC and quantity is QCWith market price PCthe firm maximizes profit by settingMR (= PC) = MC andproducing quantity qcqcD2Now assume thatdemandincreases toD2Q1P1P1With market demand D2and market supply S1equilibrium price is P1 and quantity is Q1q1Existing firms maximize profits by increasing output to q1 Excess profits inducenew firms to enterthe market The supply curve moves to the right Price falls Entry continues while profits exist Long-run equilibrium is restored at price PC and supply curve S2S2Q´C

14. 14MonopolyDerivation of the monopolist’s marginal revenueDemand: P = A - B.QTotal Revenue: TR = P.Q = A.Q - B.Q2Marginal Revenue: MR = dTR/dQ MR = A - 2B.Q With linear demand the marginalrevenue curve is also linear with the same price interceptbut twice the slope of the demand curve$/unitQuantityDemandMRA

15. 15Monopoly and Profit MaximizationThe monopolist maximizes profit by equating marginal revenue with marginal costThis is a two-stage process$/unitQuantityDemandMRACMC Stage 1: Choose output where MR = MC This gives output QM QM Stage 2: Identify the market clearing price This gives price PM PM MR is less than price Price is greater than MC: loss ofefficiency Price is greater than average costACM Positive economic profit Long-run equilibrium: no entryQCOutput by themonopolist is lessthan the perfectlycompetitiveoutput QCProfit

16. 16Efficiency and SurplusCan we reallocate resources to make some individuals better off without making others worse off?Need a measure of well-beingconsumer 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 unitaggregate consumer surplus is the sum over all units consumed and all consumers

17. 17Efficiency and Surplus 2producer surplus: difference between the amount a producer receives from the sale of a unit and the amount that unit costs to produceaggregate producer surplus is the sum over all units produced and all producers total surplus = consumer surplus + producer surplus

18. 18Quantity$/unitDemandCompetitive SupplyPCQCThe demand curve measures the willingness to pay for each unitConsumer surplus is the area between the demand curve and the equilibrium priceConsumer surplusThe supply curve measures the marginal cost of each unitProducer surplus is the area between the supply curve and the equilibrium priceProducer surplusAggregate surplus is the sum of consumer surplus and producer surplusEquilibrium occurswhere supply equalsdemand: price PC quantity QCEfficiency and surplus: illustrationThe competitive equilibrium is efficient

19. 19Deadweight loss of MonopolyDemandCompetitive SupplyQCPC$/unitMRQuantityAssume that the industry is monopolizedThe monopolist sets MR = MC to give output QMThe market clearing price is PMQMPMConsumer surplus is given by this areaAnd producer surplus is given by this areaThe monopolist produces less surplus than the competitive industry. There are mutually beneficial trades that do not take place: between QM and QCThis is the deadweightloss of monopoly

20. 20Deadweight loss of Monopoly 2Why can the monopolist not appropriate the deadweight loss?Increasing output requires a reduction in pricethis assumes that the same price is charged to everyone.The monopolist creates surplussome goes to consumerssome appears as profitThe monopolist bases her decisions purely on the surplus she gets, not on consumer surplusThe monopolist undersupplies relative to the competitive outcomeThe primary problem: the monopolist is large relative to the market

21. 21Market Structure and Market Power

22. 22IntroductionIndustries have very different structuresnumbers and size distributions of firmsready-to-eat breakfast cereals: high concentrationnewspapers: low concentrationHow best to measure market structuresummary measureconcentration curve is possiblepreference is for a single numberconcentration ratio or Herfindahl-Hirschman index

23. 23Measure of concentrationCompare 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 25 25 25 25 CR4 = 80Concentration Index H = 2,0002525

24. 24Concentration 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 56256256252525252525CR4 = 80Concentration IndexH = 2,0002525255}}}10851002,050Assume that firms4 and 5 decideto mergeThe ConcentrationIndex changesMarket shareschange

25. 25What is a market?No clear consensusthe market for automobilesshould we include light trucks; pick-ups SUVs?the market for soft drinkswhat 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 involvedhow close is close?how homogeneous do commodities have to be?Does wood compete with plastic? Rayon with wool?

26. 26Market definition 2Definition is importantwithout consistency concept of a market is meaninglessneed indication of competitiveness of a market: affected by definitionpublic policy: decisions on mergers can turn on market definitionStaples/Office Depot merger rejected on market definitionCoca Cola expansion turned on market definitionStandard approach has some consistencybased upon industrial datasubstitutability in production not consumption (ease of data collection)

27. 27The measure of concentration varies across countriesUse of production-based statistics has limitations:can put in different industries products that are in the same marketThe international dimension is importantBoeing/McDonnell-Douglas mergerrelevant market for automobiles, oil, hairdressingMarket definition 3

28. 28Geography is importantbarrier to entry if the product is expensive to transportbut customers can movewhat is the relevant market for a beach resort or ski-slope?Vertical relations between firms are importantmost firms make intermediate rather than final goodsfirm has to make a series of make-or-buy choicesupstream and downstream productionmeasures of concentration may assign firms at different stages to the same industrydo vertical relations affect underlying structure?Market definition 4

29. 29Firms at different stages may also be assigned to different industriesbottlers of soft drinks: low concentrationsuppliers of soft drinks: high concentrationthe bottling sector is probably not competitive.In sum: market definition poses real problemsexisting methods represent a reasonable compromiseMarket definition 5

30. 30Measuring Market Power/PerformanceMarket structure is often a guide to market performanceBut this is not a perfect measurecan have near competitive prices even with “few” firmsMeasure market performance using the Lerner IndexLI =P-MCP

31. 31Market Performance 2Perfect competition: LI = 0 since P = MCMonopoly: LI = 1/h – inverse of elasticity of demandWith 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 priceLI =P-SsiMCiP

32. 32Lerner Index: LimitationsLI has limitationsmeasurement: as with “measuring” a marketmeaning: measures outcome but not necessarily performancemisspecification: if there are sunk entry costs that need to be covered by positive price-cost marginlow price by a high-cost incumbent to protect its market

33. 33Empirical Application: How Bad is Market Power Really?WL =12Welfare Loss in relation to sales: WL PQ12D(LI)2 (P – MC)(QC – Q)WLPQ=1 2(P – MC) P(QC – Q) QThis can be expressed as: =

34. 34How Bad is Market Power Really? 2WL PQ12D(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

35. 35How Bad is Market Power Really? 3 WL PQ12DOne 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) P2 Corrections by Cowling and Mueller (1978) and Aiginger and Pfaffermayr (1997) raise total cost substantially to between 4 and 11 percent of GDP

36. 36Technology and Cost

37. 37The Neoclassical View of the FirmConcentrate upon a neoclassical view of the firmthe firm transforms inputs into outputsInputsOutputsThe FirmThere is an alternative approach (Coase)What happens inside firms?How are firms structured? What determines size?How are individuals organized/motivated?

38. 38Economies of scaleSources of economies of scale“the 60% rule”: capacity related to volume while cost is related to surface areaproduct specialization and the division of labor“economies of mass reserves”: economize on inventory, maintenance, repairindivisibilities

39. 39Indivisibilities make scale of entry an important strategic decision:enter large with large-scale indivisibilities: heavy overheadenter small with smaller-scale cheaper equipment: low overheadSome indivisible inputs can be redeployedaircraftOther indivisibilities are highly specialized with little value in other usesmarket research expendituresrail track between two destinationsLatter are sunk costs: nonrecoverable if production stopsSunk costs affect market structure by affecting entryIndivisibilities, sunk costs and entry

40. 40Sunk Costs and Market StructureThe greater are sunk costs the more concentrated is market structureAn example:Suppose that elasticity of demand h = 1Then total expenditure E = PQIf firms are identical then Q = NqiSuppose that LI = (P – c)/P = A/NaLerner Index is inversely related to the number of firmsSuppose firms operate in only one period: then (P – c)qi = KAs a result:Ne = AEK1/(1+)

41. 41Sources of economies of scopeshared inputssame equipment for various productsshared advertising creating a brand namemarketing and R&D expenditures that are genericcost complementaritiesproducing one good reduces the cost of producing anotheroil and natural gasoil and benzenecomputer software and computer supportretailing and product promotionEconomies of Scope

42. 42Determinants of Market StructureEconomies 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 Frankfurt2-37

43. 43Network ExternalitiesMarket structure is also affected by the presence of network externalitieswillingness to pay by a consumer increases as the number of current consumers increasetelephones, fax, Internet, Windows softwareutility from consumption increases when there are more current consumersThese markets are likely to contain a small number of firmseven if there are limited economies of scale and scope

44. 44The firm’s universe – Porter’s Five Forces

45. 45Market structuresPerfectcompetitionImperfect competitionMonopolyFirms are so small they take price as given and adapt production to maximize profitMonopolistic competiton:Many firmsBrand namesMonopolistic competition:Many firmsBrand namesOligopoly:Few firmsInter-dependenceDuopoly:Two firmsInter-depencePrivate monopolies set price to maximize profitHarder Competition SofterPossibilities for lasting superprofit

46. 46Examples of cross elasticitiesSource: Colander 1998Why are the two first elasticities different?Why is the last one negative?Are any of these products close substitutes?

47. 47Identifying the relevant market – who is the competition?Competitor’s products have similar characteristicsFord Focus and VW Golfnot Ford Focus and Jeep Grand CherokeeSame occasions for useCoca Cola and Pepsi ColaBut not Coca Cola and orange juiceCross elasticitiesHigher for closer substitutesSold in the same geographical marketDifferent markets if: sold in different places,transport of the commodity is expensive,and/or travel by consumer is expensive