Industrial Organization and Strategic Behaviour Igor Baranov Graduate School of Management St. Petersburg State University Fall 2009

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

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

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

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)

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)

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)

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

Basic Microeconomics

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

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

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

Perfect competition: an illustration With market demand D2 and market supply S1 equilibrium price is P1 and quantity is Q1 With market demand D1 and market supply S1 equilibrium price is PC and quantity is QC The supply curve moves to the right (a) The Firm (b) The Industry With market price PC the firm maximizes profit by setting MR (= PC) = MC and producing quantity qc Price falls $/unit $/unit Entry continues while profits exist Now assume that demand increases to D2 Existing firms maximize profits by increasing output to q1 Long-run equilibrium is restored MC at price PC and supply curve S2 S1 D1 AC S2 P1 P1 Excess profits induce new firms to enter the market PC PC D2 qc q1 Quantity QC Q1 Q´C Quantity

Derivation of the monopolist’s marginal revenue Monopoly Derivation of the monopolist’s marginal revenue Demand: P = A - B.Q $/unit Total Revenue: TR = P.Q = A.Q - B.Q2 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 Demand but twice the slope of the demand curve Quantity MR

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 is less than the perfectly competitive output QC Stage 2: Identify the market clearing price MC This gives price PM PM AC MR is less than price Price is greater than MC: loss of Profit efficiency Price is greater than average cost ACM Demand MR Positive economic profit Long-run equilibrium: no entry QM QC Quantity

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

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

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

Deadweight loss of Monopoly $/unit Assume that the industry is monopolized Competitive Supply The monopolist sets MR = MC to give output QM This is the deadweight loss of monopoly The market clearing price is PM PM Consumer surplus is given by this area PC 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 Demand QM QC MR Quantity

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

Market Structure and Market Power

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

Measure of concentration Compare two different measures of concentration: Firm Rank Market Share Squared Market (%) Share 1 25 625 25 2 25 625 25 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

} } } Concentration index is affected by, e.g. merger Firm Rank Market Share Squared Market (%) Share 1 25 Assume that firms 4 and 5 decide to merge 25 Market shares change 625 2 25 25 625 3 25 25 625 4 5 } 5 } 25 } 10 100 5 5 25 6 5 The Concentration Index changes 25 7 5 25 8 5 25 Concentration Index CR4 = 80 85 H = 2,000 2,050

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?

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)

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

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?

Market definition 5 In sum: market definition poses real problems 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

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 P-MC LI = P

Market Performance 2 P-SsiMCi LI = P 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 P-SsiMCi LI = P

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

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

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

How Bad is Market Power Really? 3 One problem is cost, possibly due to how advertising is treated (P – MC) 2 WL 1 = D PQ 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

Technology and Cost

The Neoclassical View of the Firm Concentrate upon a neoclassical view of the firm the firm transforms inputs into outputs Outputs Inputs The Firm There is an alternative approach (Coase) What happens inside firms? How are firms structured? What determines size? How are individuals organized/motivated?

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

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

Sunk Costs and Market Structure The greater are sunk costs the more concentrated is market structure An example: Lerner Index is inversely related to the number of firms Suppose that elasticity of demand h = 1 Then total expenditure E = PQ 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

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

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 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

The firm’s universe – Porter’s Five Forces

Market structures Harder Competition Softer Imperfect competition Monopoly Firms are so small they take price as given and adapt production to maximize profit Monopolistic competiton: Many firms Brand names Monopolistic competition: Oligopoly: Few firms Inter-dependence Duopoly: Two firms Inter-depence Private monopolies set price to maximize profit Possibilities for lasting superprofit

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?

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