Industrial Organization: Chapter 21 Chapter 2 Technology, Costs and Market Structure

Industrial Organization: Chapter 22 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

Industrial Organization: Chapter 23 Measure of concentration Compare two different measures of concentration: Firm Rank Market Share Squared Market (%) Share CR 4 = 80Concentration IndexH = 2,

Industrial Organization: Chapter 24 Concentration index is affected by, e.g. merger Firm Rank Market Share Squared Market (%) Share CR 4 = 80Concentration IndexH = 2, }}} ,050 Assume that firms 4 and 5 decide to merge The Concentration Index changes Market shares change

Industrial Organization: Chapter 25 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?

Industrial Organization: Chapter 26 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 is production not consumption (ease of data collection)

Industrial Organization: Chapter 27 Government statistical sources –FedStats –NaicsNaics 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 (cont.)

Industrial Organization: Chapter 28 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 (cont.)

Industrial Organization: Chapter 29 –Firms at different stages may also be assigned to different industries bottlers of soft drinks: low concentration suppliers of sift drinks: high concentration the bottling sector is probably not competitive. In sum: market definition poses real problems –existing methods represent a reasonable compromise Market definition (cont.)

Industrial Organization: Chapter 210 The Neoclassical View of the Firm Concentrate upon a neoclassical view of the firm –the firm transforms inputs into outputs InputsOutputs The Firm There is an alternative approach (Coase) –What happens inside firms? –How are firms structured? What determines size? –How are individuals organized/motivated?

Industrial Organization: Chapter 211 The Single-Product Firm Profit-maximizing firm must solve a related problem –minimize the cost of producing a given level of output –combines two features of the firm production function: how inputs are transformed into output Assume that there are n inputs at levels x 1 for the first, x 2 for the second,…, x n for the nth. The production function, assuming a single output, is written: Q = F(x 1, x 2, x 3,…,x n ) cost function: relationship between output choice and production costs. Derived by finding input combination that minimizes cost Minimize xixi subject to F(x 1, x 2, x 3,…,x n ) = Q 1  w i x i i=1 n

Industrial Organization: Chapter 212 Review input choice: one output and two inputs x2x2 x1x1 Q0Q0 Q1Q1 Q2Q2 The production function can be illustrated as a set of isoquants, one for each level of output The production function can be illustrated as a set of isoquants, one for each level of output Production cost can be illustrated as a set of isocost lines, with slope w 1 /w 2. The lower the isocost line, the lower the cost. Production cost can be illustrated as a set of isocost lines, with slope w 1 /w 2. The lower the isocost line, the lower the cost. Cost of producing output Q 1 is minimized by finding the point where an isocost line is tangent to the Q 1 isoquant Cost of producing output Q1 Q1 is minimized by finding the point where an isocost line is tangent to the Q1 Q1 isoquant x11x11 x12x12 The input choice is x 1 1 of input 1 and x 1 2 of input 2 The input choice is x11 x11 of input 1 and x12 x12 of input 2 Now assume that input 1 becomes cheaper This makes the isocost lines less steep The new cost- minimizing point The new cost- minimizing point More of input 1 is used and less of input 2 More of input 1 is used and less of input 2 x21x21 x22x22 The cost-minimizing input combination changes

Industrial Organization: Chapter 213 This analysis has interesting implications –different input mix across time: as capital becomes relatively cheaper space: difference in factor costs across countries Analysis gives formal definition of the cost function –denoted C(Q): total cost of producing output Q –average cost = AC(Q) = C(Q)/Q –marginal cost: additional cost of producing one more unit of output. Slope of the total cost function formally: MC(Q) = dC(Q)/d(Q)

Industrial Organization: Chapter 214 Cost curves: an illustration $/unit Quantity AC MC Typical average and marginal cost curves Relationship between AC and MC If MC < AC then AC is falling If MC > AC then AC is rising MC = AC at the minimum of the AC curve

Industrial Organization: Chapter 215 Economies of scale Definition: average costs fall with an increase in output Represented by the scale economy index S = AC(Q) MC(Q) S > 1: economies of scale S < 1: diseconomies of scale S is the inverse of the elasticity of cost with respect to output  C = dC(Q) C(Q) dQ Q = dC(Q) dQ C(Q) Q = MC(Q) AC(Q) = 1 S

Industrial Organization: Chapter 216 An example Take a simple example Output Total Cost Average Cost Marginal Cost Scale Economy ($) ($) ($)Index } } /91 = /157 = 0.78 Average cost is taken as the mean of 145 and 136 Average cost is taken as the mean of 145 and Average cost is taken as the mean of 121 and 124 Average cost is taken as the mean of 121 and 124 Check the relationship to the elasticity of the cost curve Check the relationship to the elasticity of the cost curve Percentage increase in cost of increasing output from 5 to 6( )/2 = 11.8% Percentage increase in output 6-5 (6+5)/2 = 18.2%  C = 11.8/18.2 = 0.65 and 1/  C = 1/0.65 = 1.54

Industrial Organization: Chapter 217 Minimum efficient scale: –output at which economies of scale are first exhausted $/unit Quantity AC 1 MES 1 AC 2 MES 2 With average cost curve AC 1 minimum efficient scale is MES 1 With average cost curve AC 2 minimum efficient scale is MES 2

Industrial Organization: Chapter 218 Natural monopoly If the extent of the market is less than MES then the market is a natural monopoly: S > 1 in such a market. But a natural monopoly can exist even if S < 1. 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

Industrial Organization: Chapter 219 Indivisibilities Some inputs can be employed only in indivisible units –transport routes –major items of capital equipment $ $ Quantity Q1Q1 Q1Q1 FC VC AFC AVC ATC Three implications: –cost is “lumpy” or fixed at F 1 –maximum rated capacity Q 1 –average fixed cost F 1 /Q falls with output up to rated capacity Other inputs vary with output: variable costs Average total costs exhibit economies of scale over some range F1F1

Industrial Organization: Chapter 220 If projected output is greater than current capacity install higher-rated capacity equipment or add additional capacity It may be cheaper to have spare capacity than operate up to capacity $/unit AC 1 AC 2 Quantity Q1Q1 Q2Q2 If projected output is greater than Q* it is cheaper to install higher capacity even though there is spare capacity Q* Consistent with evidence on excess capacity: see Federal Statistics

Industrial Organization: Chapter 221 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 The latter are sunk costs: nonrecoverable if production stops Fixed costs and sunk costs affect market structure by affecting entry Fixed costs, indivisibilities and sunk costs

Industrial Organization: Chapter 222 Multi-Product Firms Many firms make multiple products –Ford, General Motors, 3M etc. What do we mean by costs and output in these cases? How do we define average costs for these firms? –total cost for a two-product firm is C(Q 1, Q 2 ) –marginal cost for product 1 is MC 1 =  C(Q 1,Q 2 )/  Q 1 –but average cost cannot be defined fully generally –need a more restricted definition: ray average cost

Industrial Organization: Chapter 223 Ray average cost Assume that a firm makes two products, 1 and 2 with the quantities Q 1 and Q 2 produced in a constant ratio of 2:1. Then total output Q can be defined implicitly from the equations Q 1 = 2Q/3 and Q 2 = Q/3 More generally: assume that the two products are produced in the ratio 1 / 2 (with = 1). Then total output is defined implicitly from the equations Q 1 = 1 Q and Q 2 = 2 Q Ray average cost is then defined as: RAC(Q) = C( 1 Q, 2 Q) Q

Industrial Organization: Chapter 224 An example of ray average costs Marginal costs for each product are: C(Q 1, Q 2 ) = Q Q 2 - 3Q 1 Q 2 /2 Assume that the cost function is: MC 1 =  C(Q 1,Q 2 ) Q1Q1 = Q 2 2 MC 2 =  C(Q 1,Q 2 ) Q2Q2 = Q 1 2

Industrial Organization: Chapter 225 Ray average costs: assume 1 = 2 = 0.5 C(Q 1, Q 2 ) = Q Q 2 - 3Q 1 Q 2 /2 Q 1 = 0.5Q; Q 2 = 0.5Q RAC(Q) = C(0.5Q, 0.5Q) Q = Q/2+ 30Q/2 - 3Q 2 /8 Q = 10 Q Q 8 Now assume 1 = 0.75; 2 = 0.25 RAC(Q) = C(0.75Q, 0.25Q) Q = Q/4+ 30Q/4 - 9Q 2 /32 Q = 10 Q Q 32

Industrial Organization: Chapter 226 Economies of scale and multiple products Definition of economies of scale with a single product S = AC(Q) MC(Q) = C(Q) Q.MC(Q) Definition of economies of scale with multiple products S = C(Q 1,Q 2,…,Q n ) MC 1 Q 1 + MC 2 Q 2 + … + MC n Q n This is by analogy to the single product case –relies on the implicit assumption that output proportions are fixed –so we are looking at ray average costs in using this definition

Industrial Organization: Chapter 227 The example once again C(Q 1, Q 2 ) = Q Q 2 - 3Q 1 Q 2 /2 MC 1 = Q 2 /2 ; MC 2 = Q 1 /2 Substitute into the definition of S: S = C(Q 1,Q 2,…,Q n ) MC 1 Q 1 + MC 2 Q 2 + … + MC n Q n = Q Q 2 - 3Q 1 Q 2 /2 25Q 1 - 3Q 1 Q 2 /2 + 30Q 2 - 3Q 1 Q 2 /2 It should be obvious in this case that S > 1 This cost function exhibits global economies of scale

Industrial Organization: Chapter 228 Economies of Scope Formal definition S C = C(Q 1, 0) +C(0,Q 2 ) -C(Q 1, Q 2 ) C(Q 1, Q 2 ) The critical value in this case is S C = 0 –S C 0 : economies of scope. Take the example: S C = Q Q 2 -( Q Q 2 - 3Q 1 Q 2 /2) Q Q 2 - 3Q 1 Q 2 /2 > 0

Industrial Organization: Chapter 229 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 Economies of Scope (cont.)

Industrial Organization: Chapter 230 Flexible Manufacturing Extreme version of economies of scope Changing the face of manufacturing “Production units capable of producing a range of discrete products with a minimum of manual intervention” –Benetton –Custom Shoe –Levi’s –Mitsubishi Production units can be switched easily with little if any cost penalty –requires close contact between design and manufacturing

Industrial Organization: Chapter 231 Flexible Manufacturing (cont.) Take a simple model based on a spatial analogue. –There is some characteristic that distinguishes different varieties of a product sweetness or sugar content color texture –This can be measured and represented as a line –Individual products can be located on this line in terms of the quantity of the characteristic that they possess –One product is chosen by the firm as its base product –All other products are variants on the base product

Industrial Organization: Chapter 232 Flexible Manufacturing (cont.) An illustration: soft drinks that vary in sugar content This is the characteristics line Each product is located on the line in terms of the amount of the characteristic it has LowHigh (Diet)(LX)(Super)

Industrial Organization: Chapter 233 The example (cont.) Assume that the process is centered on LX as base product LowHigh (Diet)(LX)(Super) A switching cost s is incurred in changing the process to either of the other products. There are additional marginal costs of making Diet or Super - from adding or removing sugar. These are r per unit of “distance” between LX and the other product. There are shared costs F: design, packaging, equipment.

Industrial Organization: Chapter 234 The example (cont.) In the absence of shared costs there would be specialized firms. Shared costs introduce economies of scope. Total costs are:C(z j, q j ) =F + (m - 1)s +  j=1 m [(c + r  z j - z 1  )q j ] If production is 100 units of each product: C 3 = 3F + 300cone product per firm with three firms one firm with all three productsC 1 = F + 2s + 300c + 100r C 1 < C 3 if2s + 100r < 2F  F > 50r + s This implies a constraint on set-up costs, switching costs and marginal costs for multi-product production to be preferred.

Industrial Organization: Chapter 235 Economies of scale and scope 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 For example, entry to the medical profession is going to be more extensive in Chicago than in Oxford, Miss 2-37

Industrial Organization: Chapter 236 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

Industrial Organization: Chapter 237 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

Industrial Organization: Chapter 238 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 LI = P-MC P

Industrial Organization: Chapter 239 Market Performance (cont.) Perfect competition: LI = 0 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-  s i MC i P

Industrial Organization: Chapter 240

Industrial Organization: Chapter 241 $/unit Quantity AC 1 Assume two identical firms each with costs AC 1 If they are to produce a given output at lowest cost, they must operate at the same marginal cost MC Why? Assume firm A is operating at MC A and firm B is operating at MC B MC A MC B Transferring one unit of output from A to B lowers total cost MC´ A MC´ B If the two firms operate at the same marginal cost they must produce identical outputs Suppose not: firm A has output QA QA and firm B has output QBQB Transferring one unit of output from A to B lowers total cost QAQA QBQB

Industrial Organization: Chapter 242 $/unit Quantity AC 1 AC 2 It follows that AC 2 represents the lowest possible average cost if output is produced by two firms: AC 2 is obtained by adding AC 1 to itself horizontally This market is a natural monopoly up to output QMQM even though this is greater than MES Q*: it is less costly for output to be produced by one rather than two firms: subadditivity Q*2Q*QMQM AC 1 is average cost if output is produced by one firm. Now assume that output is produced by two firms. If total output is 2Q 1 then we know that each firm has to produce Q 1 and average cost is AC 1 If total output is 2Q 1 then we know that each firm has to produce Q 1 and average cost is AC 1 AC 1 2Q 1 Q1Q1 2Q 2 Q2Q2 If total output is 2Q 2 then we know that each firm has to produce Q 2 and average cost is AC 2 If total output is 2Q 2 then we know that each firm has to produce Q 2 and average cost is AC 2 If total output is 2Q* then we know that each firm has to produce Q* and average cost is AC* If total output is 2Q* then we know that each firm has to produce Q* and average cost is AC* AC 2 AC*

Industrial Organization: Chapter 243 Illustration of ray average costs