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

2. 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

3. 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

4. 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

5. 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)

6. 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)

7. 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)

8. 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

9. Basic Microeconomics

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. Market Structure and Market Power

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

23. Measure of concentration
Compare two different measures of concentration:
Firm Rank Market Share Squared Market (%) Share
625 25
625 25
625 25 25 25 25 25
Concentration Index
CR4 = 80
H = 2,000

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

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?

26. 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)

27. 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

28. 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?

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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= 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

35. 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

36. Technology and Cost

37. 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?

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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

44. The firm’s universe – Porter’s Five Forces

45. 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

46. 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?

47. 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