1 introduction basic tools market structure

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Industrial Organization: contemporary theory and practice (3rd edition) Lecture notes Industrial Organization: Chapter 1 Introduction • How firms behave in markets • Whole range of business issues – price of flowers; payment to be official sponsor of major events – which new products to introduce – merger decisions – methods for attacking or defending markets • Strategic view of how firms interact Industrial Organization: Chapter • How should a firm price its product given the existence of rivals? • How does a firm decide which markets to enter? • Incredible richness of examples: – – – – – Microsoft/Netscape/Sun ADM (collusion) Toys R Us (exclusive dealing) American Airlines (predatory pricing) Merger wave • At the heart of all of this is strategic interaction Industrial Organization: Chapter • Rely on the tools of game theory – focuses on strategy and interaction • Construct models: abstractions – well established tradition in all science • physics • engineering – are SUVs safe? – Do seat-belts/Volvos save lives? Industrial Organization: Chapter The New Industrial Organization • The “New Industrial Organization” is something of a departure – 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) Industrial Organization: Chapter • Do not say much about the internal organization of firms – vertical organization is discussed – internal contracts are not Industrial Organization: Chapter Anti-trust Policy: an overview • Developments in modern IO are sensitive to the policy context – Microsoft and ADM • highlight aspects of developments in policy/law and economic theory • Need for anti-trust policy recognized by Adam Smith (1776) – “The monopolists, by keeping the market constantly understocked, by never fully supplying the effectual demand, sell their commodities much above the natural price.” Industrial Organization: Chapter – “People of the same trade seldom meet together, even for merriment or diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” • Sherman Act 1890 – Section 1: prohibits contracts, combinations and conspiracies “in restraint of trade” – Section 2: makes illegal any attempt to monopolize a market – contrast per se rule • collusive agreements/price fixing – rule of reason • “unreasonable” conduct Industrial Organization: Chapter • Clayton Act (1914) – intended to prevent monopoly “in its incipiency” – makes illegal practices that “may substantially lessen competition or tend to create a monopoly” • Federal Trade Commission established in the same year • However, application affected by rule of reason – proof of intent – “the law does not make mere size an offence or the existence of unexerted power an offence - it does not compel competition nor require all that is possible.” Industrial Organization: Chapter • Robinson-Patman (1936) – prohibits price discrimination that is intended to lessen competition – intended to prevent aggressive price discounting • The Alcoa case (1945) was also important – 90% market share – expanded capacity in advance of market expansion – inferred anti-trust violation from structure and conduct without overt evidence • More relaxed attitude in last two decades – emergence of large firms: merger waves – importance of global competition Industrial Organization: Chapter 10 Example (cont.) • Monopolist has 200 units • Reservation prices: Number of Buyers First 100 Reservation Price $50,000 Next 40,000 $15,000 Last 9,900 $10,000 Now there is a loss of efficiency and so deadweight loss no matter what the monopolist does Chapter 2: Basic Microeconomic Tools 36 Market Structure and Market Power Chapter 3: Market Structure and Market Power 37 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 Chapter 3: Market Structure and Market Power 38 Measure of concentration • Compare two different measures of concentration: Firm Rank Market Share (%) Squared Market Share 25 625 25 625 25 625 25 5 25 25 25 25 Concentration Index CR4 = 80 Chapter 3: Market Structure and Market Power H = 2,000 39 • Concentration index is affected by, e.g merger Firm Rank Market Share (%) Assume that firms and decide to merge 25 5 } 25 625 Market shares 625 change 25 625 The Concentration Index changes Concentration Index Squared Market Share } 10 25 25 25 25 25 CR4 = 80 85 Chapter 3: Market Structure and Market Power } H = 2,000 100 2,050 40 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 McDonalds and Burger King compete? • Presumably define a market by closeness in substitutability of the commodities involved – how close is close? – how homogeneous commodities have to be? • Does wood compete with plastic? Rayon with wool? Chapter 3: Market Structure and Market Power 41 Market definition (cont.) • 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) Chapter 3: Market Structure and Market Power 42 Market definition (cont.) • Government statistical sources – FedStats – Naics • 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 Chapter 3: Market Structure and Market Power 43 Market definition (cont.) • 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 • vertical relations affect underlying structure? Chapter 3: Market Structure and Market Power 44 Market definition (cont.) – 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 Chapter 3: Market Structure and Market Power 45 The Role of Policy • Government can directly affect market structure – by limiting entry • taxi medallions in Boston and New York • airline regulation – through the patent system – by protecting competition e.g through the Robinson-Patman Act Chapter 3: Market Structure and Market Power 46 Market 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 P-MC LI = P Chapter 3: Market Structure and Market Power 47 Market Performance (cont.) • Perfect competition: LI = since P = MC • Monopoly: LI = 1/– inverse of elasticity of demand • With more than one but not “many” firms, the Lerner Index is more complicated: need to average – suppose the goods are homogeneous so all firms sell at the same price LI = P-siMCi P Chapter 3: Market Structure and Market Power 48 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 Chapter 3: Market Structure and Market Power 49 Fast-Food Outlets McDonald’ s Burger King Wendy’ s Chapter 3: Market Structure and Market Power 50 ... to $1, 102.50 in a further year so the contract is for $1, 102.50 note: $1, 102.50 = $1, 000 x 1. 05 x 1. 05 = $1, 000 x 1. 052 • More generally – a loan of Y for years at interest rate r grows to Y (1. .. D and market and marketsupply supplySS 111 (a) The Firm (b) The Industry and market SS1P • Price falls and marketsupply supply equilibrium price With 1P equilibrium priceisis Withmarket marketprice... Example 1: Three firms Firm Firm Firm Firm 1: qMC = MC/4 = 4q +- 82 q1+q2+q3 Firm 2: qMC = MC/2 = 2q +- 84 Firm 3: qMC = MC/6 = 6q +- 84/3 Invert these Aggregate: Q= q1+q2+q3 = 11 MC /12 - 22/3 MC = 12 Q /11
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