Industrial Organization

Igor Baranov Graduate School of Management St. Petersburg State University

Fall 2008

1 Introduction

WHAT is

• 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 – 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 power – Sherman Antitrust Act (1890) • Section 1: prohibits contracts, combinations and conspiracies “in restraint of ” • Section 2: makes illegal any attempt to monopolize a market – Regulation

• Theory of Business Strategy

4 Structure, Conduct, and Performance

• The Structure-Conduct-Performance Model – Spectrum of markets: pure --pure – Closer to monopoly means worse loss – IO mission is to identify link from to firm conduct (pricing, advertising, etc) to market outcomes ()

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 () • 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 • WHAT: – The study of 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 in private solutions to inefficient market outcomes

7 Basic

8 Profitability

• Accounting = sales revenue – accounting cost • Economic profit = accounting profit less – Opportunity cost is of resource from use in best alternative forgone – Economic profit is always less than or equal to accounting profit – If positive – will cause entry of new firms/investors into market – If negative – will cause exit of firms/investors from market – If zero – a normal profit is earned relative to risk – no particular incentives for entry or exit of market • Normal profit is an opportunity cost of the invested capital • Economic profit = Accounting profit less normal profit • Superprofit  positive economic profit • We assume that the goal of the firm is to maximize profit

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 -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, equals price

• To maximize profit a firm of any type must equate marginal revenue with

• So in perfect competition price equals marginal cost

11 Perfect competition: an illustration

• The curve moves to the rightWithWith market market demand D D2 With market demand D 2 (a) The Firm (b)With Theandand Industrymarket market market demand supply supply S DS111 • Price falls 1 andequilibriumand market market supply supplyprice isS S 1P WithWith market market price price P PC equilibrium price is 1P11 $/unit C $/unit equilibriumand quantity price isis QP the firm maximizes • Entry continues while profits existequilibriumand quantity price isis QP1CC the firm maximizes and quantityNowNow assume assume is Q that that1 profit by setting and quantity is QCC profit by setting •ExistingExistingMCLong-run firms firmsequilibrium maximize maximize is restored demanddemand MRMR (= (= P PC)) = = MC MC and and atprofits price P byC and increasing supply curve S2 increases to C profits by increasingD increasesS1 to producing quantity q 1 D producing quantity qc outputAC to q D22 c output to q11 S P1 P1 2 ExcessExcess profits profits induce induce newnew firms firms to to enter Penter PC C thethe market market D2

qc q1 Quantity QC Q1 Q´C Quantity

12 Monopoly

• Derivation of the monopolist’s marginal revenue

Demand: P = A - B.Q $/unit 2 Total Revenue: TR = P.Q = A.Q - B.Q A Marginal Revenue: MR = dTR/dQ  MR = A - 2B.Q

With linear demand the marginal Demand revenue curve is also linear with the same price intercept but twice the slope of the demand Quantity curve MR

13 Monopoly and • 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 Q OutputOutput by by the the M monopolistmonopolist is isStage less less 2: Identify the market clearing price MC thanthan the the perfectly perfectly This gives price PM competitivecompetitive output QC PM outputAC QC MR is less than price Price is greater than MC: loss of Profit efficiency Price is greater than ACM Demand MR Positive economic profit Long-run equilibrium: no entry QM QC Quantity 14 Efficiency and Surplus

• Can we reallocate resources to make some individuals better off without making others worse off? • Need a measure of well-being – consumer surplus: difference between the maximum amount a consumer is willing to pay for a unit of a good and the amount actually paid for that unit • aggregate consumer surplus is the sum over all units consumed and all consumers – producer surplus: difference between the amount a producer receives from the sale of a unit and the amount that unit costs to produce • aggregate producer surplus is the sum over all units produced and all producers – total surplus = consumer surplus + producer surplus

15 Efficiency and surplus: illustration

$/unit The measures the Competitive willingness to pay for each unit Consumer surplus is the area Supply between the demand curve and the equilibrium price Consumer Equilibrium occurs The supply curve measures the surplus Equilibrium occurs P where supply equals marginal cost of each unit C where supply equals Producer demand:demand: price price P PC Producer surplus is the area C surplus quantityquantity Q QC between the supply curve and the C equilibrium price Demand Aggregate surplus is the sum of consumer surplus and producer surplus The is QC Quantity efficient

16 Deadweight loss of Monopoly

$/unit Assume that the industry is monopolized Competitive The monopolist sets MR = MC to Supply This is the deadweight give output QM This is the deadweight losslossofof monopoly monopoly The market clearing price is PM P Consumer surplus is given by this M area And producer surplus is given by PC this area

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

17 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

18 Market Structure and

19 The firm’s universe – Porter’s Five Forces

20 Market structures

Harder Competition Softer

Perfect Imperfect competition Monopoly competition

Firms are so MonopolisticMonopolistic : : Private small they competitioncompetiton: •Few firms •Two firms take price as ••ManyManyfirmsfirms •Inter- •Inter- set price to given and ••BrandBrand namesnames dependence depence maximize adapt profit production Possibilities for lasting to maximize superprofit profit

21 Introduction

• Industries have very different structures – numbers and size distributions of firms • mobile communications, diapers: high concentration • newspapers: low concentration

• How best to measure market structure – summary measure – concentration curve is possible – is for a single number – concentration ratio or Herfindahl-Hirschman

22 Measure of concentration

• Compare two different measures of concentration:

Firm Rank Market Share Squared Market (%) 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 Squared Market (%) Share 1 Assume that firms 25 625 Market shares 4 and 5 decide 2 25 change 625 to merge 3 25 625 4 5 25 } } 10 } 100 5 5 25 6 5 25 The Concentration 7 Index changes 5 25 8 5 25

Concentration Index CR4 = 80 85 H = 2,000 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?

25 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

26 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?

27 Defining the geographic market

1) Where do consumers live? • Identify core area. E.g. register postal code on sales • Which competitors are within the geographical area?

2) Survey of residents in the core area regarding shopping habits in- and outside area.

Elzinga and Hogarty (1978); well-defined geographic area if: A) Firms in the market draw most (80-90%) of the customers from the market, and B) those who live in the market do most of the purchases from firms in the market

28 Market definition

• Definition is important – without consistency concept of a market is meaningless – need indication of competitiveness of a market: affected by definition – public policy: decisions on mergers can turn on market definition • Staples/Office Depot merger rejected on market definition • Coca Cola expansion turned on market definition

• Standard approach has some consistency – based upon industrial data – substitutability in production not consumption (ease of data collection)

29 Market definition 2

• Government statistical sources (for US: FedStats)

• The measure of concentration varies across countries

• Use of production-based statistics has limitations: – can put in different industries products that are in the same market

• The international dimension is important – Boeing/McDonnell-Douglas merger – relevant market for automobiles, oil, hairdressing

• Geography is important – barrier to entry if the product is expensive to transport – but customers can move • what is the relevant market for a beach resort or ski-slope?

30 Market definition 3

• Vertical relations between firms are important – most firms make intermediate rather than final – firm has to make a series of make-or-buy choices – upstream and downstream production – measures of concentration may assign firms at different stages to the same industry • do vertical relations affect underlying structure? – firms at different stages may also be assigned to different industries • bottlers of soft drinks: low concentration • suppliers of soft drinks: high concentration • the bottling sector is probably not competitive. • In sum: market definition poses real problems – existing methods represent a reasonable compromise

31 The Role of Policy

• Government can directly affect market structure – by limiting entry • license (taxi etc.) • airline regulation – through the patent system – by protecting competition e.g. through the Robinson- Patman Act

32 Measuring Market Power/Performance

• Market structure is often a guide to market performance • But this is not a perfect measure – can have near competitive even with “few” firms • Measure market performance using the Lerner Index P-MC LI = P

• Perfect competition: LI = 0 since P = MC • Monopoly: LI = 1/– inverse of 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

33 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

34 Empirical Application: How Bad is Market Power Really?

• Harberger (1954) exercise: Welfare Loss (WL) is: 1 C WL = 2 (P – MC)(Q – Q) • Welfare Loss in relation to sales: (QC – Q) WL = 1 (P – MC) PQ 2 P Q • This can be expressed as: WL 1 2 = D(LI) PQ 2

35 How Bad is Market Power Really? 2

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

WL 1 2 = D(LI) 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

36 How Bad is Market Power Really? 3

• One problem is cost, possibly due to how advertising is treated (P – MC) 2 WL = 1  PQ 2 D 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

37 Technology and Cost

38 The Neoclassical View of the Firm

• Concentrate upon a neoclassical view of the firm – the firm transforms inputs into outputs

Inputs Outputs

The Firm

• There is an alternative approach (Coase) – What happens inside firms? – How are firms structured? What determines size? – How are individuals organized/motivated?

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• 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

40 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 • Latter are sunk costs: nonrecoverable if production stops

• Sunk costs affect market structure by affecting entry

41 Sunk Costs and Market Structure

• The greater are sunk costs the more concentrated is market structure • An example: Suppose that elasticity of demand  = 1 Lerner Index is Then total expenditure E = PQ inversely related to 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+) Ne = K

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• Sources of economies of scope

• Shared inputs – same equipment for various products – shared advertising creating a brand name – marketing and R&D expenditures that are generic

• Cost complementarities – producing one good reduces the cost of producing another – oil and natural gas – oil and benzene – computer software and computer support – retailing and product promotion

43 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 companies in Wall Street, New York than in Frankfurt

442-37 Network

• 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 • 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

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