Download EC 170: Industrial Organization

Industrial Organization
and Strategic Behaviour
Igor Baranov
Graduate School of Management
St. Petersburg State University
Fall 2009
1
Introduction
WHAT is Industrial Organization
• Study of How firms behave in markets
• Whole range of business issues
–
–
–
–
pricing decisions
which new products to introduce
merger decisions
methods for attacking or defending markets
• Industrial Organization takes a Strategic view of
how firms interact
2
Industrial Organization In Practice
HOW Industrial Organization proceeds in practice
• Rely on the tools of game theory
– focuses on strategy and interaction
• Construct models: abstractions
– well established tradition in all science
– Simplification but gain the power of generalization
• Empirical Analysis—Use theory to form testable
hypotheses
– for entry deterring actions
– examine the impact of advertising
3
Motivation for Industrial Organization Study
WHY do Industrial Organization?
• Long-standing concern with market power
– Sherman Antitrust Act (1890)
• Section 1: prohibits contracts, combinations and conspiracies “in
restraint of trade”
• Section 2: makes illegal any attempt to monopolize a market
– Regulation Economics
• Theory of Business Strategy
4
Structure, Conduct, and Performance
• The Structure-Conduct-Performance Model
– Spectrum of markets: pure competition--pure
monopoly
– Closer to monopoly means worse welfare loss
– IO mission is to identify link from market structure
to firm conduct (pricing, advertising, etc) to market
outcomes (deadweight loss)
5
Chicago and Post-Chicago Frameworks
• The Chicago School
– Good as well as bad reasons for monopoly including
superior skill and technology
– Potential entry can discipline even a monopoly
– Structure is endogenous/causality difficult to determine
• Post-Chicago
– Game Theoretic Emphasis
– Competitive Discipline can Fail
– Careful econometric testing to determine correct policy
in actual cases
• ADM (collusion)
• Toys R Us (exclusive dealing)
• American Airlines (predatory pricing)
• Merger wave (Maytag and Whirlpool)
6
The New Industrial Organization
• The “New Industrial Organization” is a blend of
features
– theory in advance of policy
– recognition of connection between market structure and
firms’ behavior
• Contrast pricing behavior of:
–
–
–
–
grain farmers at first point of sale
gas stations: Texaco, Mobil, Exxon
computer manufacturers
pharmaceuticals (proprietary vs. generics)
7
Contemporary Industrial Organization
• WHAT: The study of imperfect competition and
strategic interaction
• HOW:
– Build on game theory foundation
– Derive empirically testable propositions
– Econometric estimates of relations predicted by theory
• WHY:
– Motivated largely by antitrust concerns
– Also interest in private solutions to inefficient
market outcomes
8
Basic Microeconomics
9
Efficiency and Market Performance
• Contrast two polar cases
– perfect competition
– monopoly
• What is efficiency?
– no reallocation of the available resources makes one economic
agent better off without making some other economic agent
worse off
10
Perfect Competition
• Firms and consumers are price-takers
• Firm can sell as much as it likes at the ruling market price
– do not need many firms
– do need the idea that firms believe that their actions will not affect the
market price
• Therefore, marginal revenue equals price
• To maximize profit a firm of any type must equate marginal revenue
with marginal cost
• So in perfect competition price equals marginal cost
11
The First Order Condition: MR = MC
•
•
•
•
•
•
Profit is p(q) = R(q) - C(q)
Profit maximization: dp/dq = 0
This implies dR(q)/dq - dC(q)/dq = 0
But dR(q)/dq = marginal revenue
dC(q)/dq = marginal cost
So profit maximization implies MR = MC
12
Perfect competition: an illustration
With market price PC
$/unit
the firm maximizes
profit by setting
MR (= PC) = MC and
producing quantity qc
With market demand D2
• The supply curve moves to the right
andmarket
marketdemand
supplyDS11
(a) The Firm
(b)With
The
Industry
• Price falls
and
market supply
S1P1
equilibrium
price is
equilibrium
price isis Q
P1C
$/unitprofits exist
and quantity
• Entry continues while
Now assume
and quantity
is QCthat
MC
demand
maximize
•Existing
Long-runfirms
equilibrium
is restored
increases
atprofits
price Pby
supply curve S2
increasing
C and
S1 to
D1
D2
output
AC to q1
P1
S2
P1
Excess profits induce
new firms to enter
PC
the market
PC
D2
qc q1
Quantity
QC
Q1 Q´C
Quantity
13
Monopoly
• Derivation of the monopolist’s marginal revenue
Demand: P = A - B.Q
Total Revenue: TR = P.Q = A.Q - B.Q2
$/unit
A
Marginal Revenue: MR = dTR/dQ
 MR = A - 2B.Q
With linear demand the marginal
revenue curve is also linear with
the same price intercept
but twice the slope of the demand
curve
Demand
MR
Quantity
14
Monopoly and Profit Maximization
• The monopolist maximizes profit by equating marginal
revenue with marginal cost
• This is a two-stage process
Stage 1: Choose output where MR = MC
$/unit
This gives output QM
Output by the
monopolist isStage
less 2: Identify the market clearing price
MC
than the perfectly
This gives price PM
competitive
output
AC QC
MR is less than price
Price is greater than MC: loss of
efficiency
Price is greater than average cost
Demand
PM
Profit
ACM
MR
QM QC
Quantity
Positive economic profit
Long-run equilibrium: no entry
15
Efficiency and Surplus
• Can we reallocate resources to make some
individuals better off without making others worse
off?
• Need a measure of well-being
– consumer surplus: difference between the maximum
amount a consumer is willing to pay for a unit of a
good and the amount actually paid for that unit
– aggregate consumer surplus is the sum over all units
consumed and all consumers
16
Efficiency and Surplus 2
– producer surplus: difference between the amount
a producer receives from the sale of a unit and the
amount that unit costs to produce
– aggregate producer surplus is the sum over all
units produced and all producers
– total surplus = consumer surplus + producer
surplus
17
Efficiency and surplus: illustration
$/unit
The demand curve measures the
willingness to pay for each unit
Consumer surplus is the area
between the demand curve and the
equilibrium price
The supply curve measures the
marginal cost of each unit
Producer surplus is the area
between the supply curve and the
equilibrium price
Competitive
Supply
PC
Consumer
surplus
Equilibrium occurs
where supply equals
demand: price PC
quantity QC
Producer
surplus
Demand
Aggregate surplus is the sum of
consumer surplus and producer surplus
The competitive equilibrium is
efficient
QC
Quantity
18
Deadweight loss of Monopoly
Assume that the industry is
monopolized
The monopolist sets MR = MC to
give output QM
The market clearing price is PM
Consumer surplus is given by this
area
And producer surplus is given by
this area
The monopolist produces less
surplus than the competitive
industry. There are mutually
beneficial trades that do not take
place: between QM and QC
$/unit
This is the deadweight
loss of monopoly
Competitive
Supply
PM
PC
Demand
QM
QC MR
Quantity
19
Deadweight loss of Monopoly 2
• Why can the monopolist not appropriate the deadweight loss?
– Increasing output requires a reduction in price
– this assumes that the same price is charged to everyone.
• The monopolist creates surplus
– some goes to consumers
– some appears as profit
• The monopolist bases her decisions purely on the surplus she gets,
not on consumer surplus
• The monopolist undersupplies relative to the competitive outcome
• The primary problem: the monopolist is large relative to the market
20
Market Structure and Market
Power
21
Introduction
• Industries have very different structures
– numbers and size distributions of firms
• ready-to-eat breakfast cereals: high concentration
• newspapers: low concentration
• How best to measure market structure
–
–
–
–
summary measure
concentration curve is possible
preference is for a single number
concentration ratio or Herfindahl-Hirschman index
22
Measure of concentration
• Compare two different measures of concentration:
Firm Rank
Market
Market Share
(%)
Squared
Share
1
25
625
2
25
625
3
25
625
4
5
25
5
5
25
6
5
25
7
5
25
8
5
25
Concentration Index
CR4 = 80
H = 2,000
23
Concentration index is affected by, e.g. merger
Firm Rank
Market Share
(%)
1 Assume that firms
2 4 and 5 decide
to merge
3
25
4
5
5
6
7
}
25
625
Market shares
625
change
25
625
5
The Concentration
Index changes
8
Concentration Index
Squared Market
Share
}
10
25
25
5
25
5
25
5
25
CR4 = 80
85
H = 2,000
}
100
2,050
24
What is a market?
• No clear consensus
– the market for automobiles
• should we include light trucks; pick-ups SUVs?
– the market for soft drinks
• what are the competitors for Coca Cola and Pepsi?
– With whom do McDonalds and Burger King compete?
• Presumably define a market by closeness in
substitutability of the commodities involved
– how close is close?
– how homogeneous do commodities have to be?
• Does wood compete with plastic? Rayon with wool?
25
Market definition 2
• Definition is important
– without consistency concept of a market is meaningless
– need indication of competitiveness of a market: affected by
definition
– public policy: decisions on mergers can turn on market
definition
• Staples/Office Depot merger rejected on market definition
• Coca Cola expansion turned on market definition
• Standard approach has some consistency
– based upon industrial data
– substitutability in production not consumption (ease of data
collection)
26
Market definition 3
• The measure of concentration varies across countries
• Use of production-based statistics has limitations:
– can put in different industries products that are in the same
market
• The international dimension is important
– Boeing/McDonnell-Douglas merger
– relevant market for automobiles, oil, hairdressing
27
Market definition 4
• Geography is important
– barrier to entry if the product is expensive to transport
– but customers can move
• what is the relevant market for a beach resort or ski-slope?
• Vertical relations between firms are important
–
–
–
–
most firms make intermediate rather than final goods
firm has to make a series of make-or-buy choices
upstream and downstream production
measures of concentration may assign firms at different stages
to the same industry
• do vertical relations affect underlying structure?
28
Market definition 5
– Firms at different stages may also be assigned to different
industries
• bottlers of soft drinks: low concentration
• suppliers of soft drinks: high concentration
• the bottling sector is probably not competitive.
• In sum: market definition poses real problems
– existing methods represent a reasonable compromise
29
Measuring Market Power/Performance
• Market structure is often a guide to market
performance
• But this is not a perfect measure
– can have near competitive prices even with “few” firms
• Measure market performance using the Lerner Index
LI =
P-MC
P
30
Market Performance 2
• Perfect competition: LI = 0 since P = MC
• Monopoly: LI = 1/h – inverse of elasticity of demand
• With more than one but not “many” firms, the
Lerner Index is more complicated: need to average.
– suppose the goods are homogeneous so all firms sell at the
same price
LI =
P-SsiMCi
P
31
Lerner Index: Limitations
• LI has limitations
– measurement: as with “measuring” a market
– meaning: measures outcome but not necessarily
performance
– misspecification:
• if there are sunk entry costs that need to be covered by
positive price-cost margin
• low price by a high-cost incumbent to protect its market
32
Empirical Application: How Bad is Market Power Really?
•
1
C – Q)
(P
–
MC)(Q
WL = 2
• Welfare Loss in relation to sales:
WL = 1 (P – MC) (QC – Q)
Q
P
2
PQ
• This can be expressed as:
WL = 1  (LI)2
D
PQ
2
33
How Bad is Market Power Really? 2
• Because most industries are not perfect monopolies,
Harberger (1954) calculates
WL = 1 D (LI)2
PQ
2
• For 73 manufacturing industries assuming D=1.
Multiplying the result by each industry’s output
and summing over all industries he estimates a
total welfare loss from monopoly power of
about two-tenths of one percent of gdp
34
How Bad is Market Power Really? 3
• One problem is cost, possibly due to how advertising is
treated
WL = 1 
2 D
PQ
(P – MC) 2
P
• Under imperfect competition, MC may not be
minimized, so P – MC may be artificially low.
• Corrections by Cowling and Mueller (1978) and
Aiginger and Pfaffermayr (1997) raise total cost
substantially to between 4 and 11 percent of GDP
35
Technology and Cost
36
The Neoclassical View of the Firm
• Concentrate upon a neoclassical view of the firm
– the firm transforms inputs into outputs
Inputs
Outputs
The Firm
• There is an alternative approach (Coase)
– What happens inside firms?
– How are firms structured? What determines size?
– How are individuals organized/motivated?
37
Economies of scale
• Sources of economies of scale
– “the 60% rule”: capacity related to volume while
cost is related to surface area
– product specialization and the division of labor
– “economies of mass reserves”: economize on
inventory, maintenance, repair
– indivisibilities
38
Indivisibilities, sunk costs and entry
• Indivisibilities make scale of entry an important strategic
decision:
– enter large with large-scale indivisibilities: heavy overhead
– enter small with smaller-scale cheaper equipment: low overhead
• Some indivisible inputs can be redeployed
– aircraft
• Other indivisibilities are highly specialized with little value
in other uses
– market research expenditures
– rail track between two destinations
• Latter are sunk costs: nonrecoverable if production stops
• Sunk costs affect market structure by affecting entry
39
Sunk Costs and Market Structure
• The greater are sunk costs the more concentrated is
market structure
• An example:
Lerner Index is
Suppose that elasticity of demand h = 1
inversely related to
Then total expenditure E = PQ
the number of firms
If firms are identical then Q = Nqi
Suppose that LI = (P – c)/P = A/Na
Suppose firms operate in only one period: then (P – c)qi = K
As a result:
AE 1/(1+)
e
N =
K
40
Economies of Scope
• Sources of economies of scope
• shared inputs
– same equipment for various products
– shared advertising creating a brand name
– marketing and R&D expenditures that are generic
• cost complementarities
–
–
–
–
–
producing one good reduces the cost of producing another
oil and natural gas
oil and benzene
computer software and computer support
retailing and product promotion
41
Determinants of Market Structure
• Economies of scale and scope affect market structure
but cannot be looked at in isolation.
• They must be considered relative to market size.
• Should see concentration decline as market size
increases
– Find more extensive range of financial service companies in
Wall Street, New York than in Frankfurt
42
2-37
Network Externalities
• Market structure is also affected by the presence of
network externalities
– willingness to pay by a consumer increases as the number of
current consumers increase
• telephones, fax, Internet, Windows software
• utility from consumption increases when there are more current
consumers
• These markets are likely to contain a small number of
firms
– even if there are limited economies of scale and scope
43
The firm’s universe – Porter’s Five Forces
44
Market structures
Harder
Perfect
competition
Firms are so
small they
take price as
given and
adapt
production
to maximize
profit
Competition
Softer
Imperfect competition
Monopolistic
Monopolistic
competiton:
competition:
•Manyfirms
firms
•Many
•Brandnames
names
•Brand
Oligopoly:
•Few firms
•Interdependence
Duopoly:
•Two firms
•Interdepence
Monopoly
Private
monopolies
set price to
maximize
profit
Possibilities for lasting
superprofit
45
Examples of cross elasticities
Source: Colander 1998
Why are the two first elasticities different?
Why is the last one negative?
Are any of these products close substitutes?
46
Identifying the relevant market – who is the competition?
•
Competitor’s products have similar characteristics
–
Ford Focus and VW Golf
–
not Ford Focus and Jeep Grand Cherokee
•
Same occasions for use
–
Coca Cola and Pepsi Cola
–
But not Coca Cola and orange juice
•
Cross elasticities
–
•
Higher for closer substitutes
Sold in the same geographical market
Different markets if:
–
sold in different places,
–
transport of the commodity is expensive,
–
and/or travel by consumer is expensive
47