Industrial Organization or Imperfect Competition

1
Industrial Organization or Imperfect Competition

• Univ. Prof. dr. Maarten Janssen
• University of Vienna
• Summer semester 2008

2
Introductory Remarks I

• Overview
• study of firms and markets
• strategic competition
• Different forms of competition
• Prices
• Setting quantities
• Advertising
• Product differentiation
• Dynamic (with/without entry, exit)

3
Introductory Remarks II

• How firms behave in markets
• Whole range of business, competition issues
• price of flowers
• which new products to introduce
• merger decisions
• Prevent entry (or other abuses of dominance)
• methods for attacking or defending markets

4
Introductory Remarks III

• Strategic view of how firms interact (game
  theory)
• 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
• Construct models abstractions

5
Structure-Conduct-performance Paradigm

• The Causal View

Markt Structure
Conduct
Performance

• A lot of empirical research without clear
  theoretical bakground
• The Feedback Critique
• No one-way causation.

6
The New Industrial Organization

• Dissatisfaction with the structure-conduct-perform
  ance approach
• collect profit data on firms in an industry
• explain differences using information on size,
  organization, RD, financial leverage etc.
• but what is the direction of causation?
• More concentration leads to anti-competitive
  behaviour or low cost firms have higher market
  share and these firms are more profitable
  (Chicago)
• Threat of entry may be enough to force to behave
  competitively
• New IO strategic decision-making / game theory

7
What we will do in the course?

• Different aspects of monopoly behaviour
• Dynamic issues, different types of price
  discrimination
• Price competition
• Product differentiation, capacity constraints,
  incomplete consumer information
• Entry and Entry deterrence
• Excess capacity, limit pricing (Bayesian equil.)
• Collusion, Mergers, RD

8
Evaluation

• Two Midterms (50) and Final Examination (50)
• Active participation and tutorials
  (exercises-once every two weeks from beginning of
  April onwards-to be scheduled)
• Course outline may still change a little bit
  (Euro 2008)

9
Efficiency and Market Performance

• What is efficiency? (yardstick for evaluation)
• no reallocation of the available resources makes
  one economic agent better off without making some
  other economic agent worse off
• example given an initial distribution of food
  aid will trade between recipients improve
  efficiency?
• Contrast two polar cases (where strategic effects
  are absent)
• perfect competition
• monopoly

10
Monopoly

• One firm serves the relevant market
• What does a firm have to decide? - Which
  products to produce?
• - How to make itself visible to consumers? -
  How much to invest in RD (dynamic
  consideration)
• - How much to produce and at which price?
• Standard theory studies last question
• Objective maximize profits
• What does a firm need to know? - revenue
  (demand) side - Cost side

11
Demand curve two interpretations(Discrete case)
First Interpretation How much demanded at which
price?
Second Interpretation Marginal willingness to
pay for additional unit (For first unit 8, for
second 6, etc.)
Consumer surplus Difference between what
consumer is maximally willing to pay for some
units and what he actually had to pay
12
When is consumer surplus appropriate measure of
consumer welfare I

• Normally, consumer evaluates U(x,y,z,), where x,
  y, z are different consumption goods
• Consumer Welfare measured by U
• Optimal decisions price ratio equals ratio of
  marginal utilities
• Suppose we can write utility as V(x) m, where m
  is money summarizing other goods (with price
  normalized to 1)
• Optimal decision V(x) p

13
When is consumer surplus appropriate measure of
consumer welfare II

• If V(x) lt 0, then
• And V(x) is consumers demand curve and area
  under V(x) measures consumer welfare

V
x
14
Monopoly

• The only firm in the market
• market demand is the firms demand
• output decisions affect market clearing price

Marginal revenue from a change in price is
the net addition to revenue generated by the
price change G - L
/unit
Loss of revenue from the reduction in price of
units currently being sold (L)
P1
Gain in revenue from the sale of additional
units (G)
L
P2
G
Demand
Q1
Q2
Quantity
15
Marginal Revenues Monopolist
Marginal revenue
Elastic
Inelastic
Total Revenue ()
MR
Total revenuePQ
16
Cost Analysis

• Type of Costs
• Fixed cost (FC)
• Variable cost (VC)
• Marginal cost (MC)
• Total cost (TC)
• Sunk cost
• Opportunity cost

17
Fixed costs and sunk costs

• sunk costs nonrecoverable if production stops
  (highly specialized cost items with little value
  in other uses)
• market research expenditures
• rail track between two destinations
• Fixed costs and sunk costs affect market
  structure by affecting entry

18
Total Cost
C(Q) Minimal total cost one has to make to
produce Q units C(Q) VC(Q)
FC VC(Q)Variable Cost FC Fixed Cost
19
Some Definitions
Average Total Cost ATC AVC AFC ATC
C(Q)/Q Average Variable Cost AVC
VC(Q)/Q Average Fixed Cost AFC FC/Q Marginal
Cost MC DC/DQ
ATC
AVC
AFC
20
Fixed and Variable Cost
ATC
Fixed Cost
AFC
AVC
Variable Cost
Q0
21
Economies of scale

AC
Economies of scale
Diseconomies of scale
Output
MES
22
Economies of scale

• Definition average costs fall with an increase
  in output
• Represented by the scale economy index

AC(Q)
S
MC(Q)

• S gt 1 economies of scale
• S lt 1 diseconomies of scale
• Cost sub-additivity C(Q) lt Si1,,N C(qi), with
  Q Si1,,N qi , for all N

23
Economies of Scope
C(Q1, 0)
C(0 ,Q2) gt
C(Q1, Q2)

• Sources of economies of scope
• shared inputs
• shared advertising creating a brand name
• cost complementarities (producing one good
  reduces the cost of producing another)

24
Profit maximisation Monopolist
Profit
PM
ATC
D
QM
MR
Profit p P(Q)Q C(Q)
Pricing rule
25
Intermezzo I KLM

• Why are tickets Amsterdam Vienna more expensive
  with KLM than identical tickets Vienna
  Amsterdam?
• What is the relevant market?
• Ineficiency price is above marginal cost and
  some consumers are willing to buy at a lisghtly
  reduced price. This is better for all why does
  the monopolist ot set a lower rice?

26
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
• producer surplus difference between the amount a
  producer receives from the sale of a unit and the
  amount that unit costs to produce
• total surplus consumer surplus producer
  surplus

27
Efficiency and surplus competitive illustration
/unit
Competitive Supply
Consumer surplus
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
Quantity
QC
28
Illustration (cont.)
/unit
Assume that a greater quantity QG is traded
The net effect is a reduction in total surplus
Competitive Supply
Price falls to PG
Producer surplus is now a positive part
and a negative part
PC
Consumer surplus increases
PG
Part of this is a transfer from producers
Demand
Part offsets the negative producer surplus
Quantity
QC
QG
29
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
QC
MR
Quantity
QM
30
Monopoly and Competition

• When do we get which situation?
• Formally one supplier vs. many
• In what type of industries may we expect many?
  (cost reasons)

31
Structural Sources of Monopoly Power

• Technological when production costs are
  minimized concentrating output in a single firm.
  (sub-additivity)
• Entry costs Sunk nature of cost involved in
  entry
• Absolute cost advantages of incumbent.
• Sunk expenditures by consumers (switching costs)

32
Natural monopoly

• An industry is a natural monopoly if the
  production of a particular good or service by a
  single firm minimizes cost.
• In the Figure, there are economies of scale at
  all relevant outputs

33
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?

34
General methodology

• Investigate to what extent goods are substitutes
  for each other
• if one firm/product changes its price to what
  extent is demand for another firm/product
  affected?
• If the answer is quite a bit, then products are
  in one market
• One important measure is cross price elasticity
• SSNIP test / cellophane fallacy

35
Example 1 printers and cartridges

• There are different printer brands that can be
  connected to your PC. Each brand has a cartridge
  that only fits its own design printer
• Is there a market for printers that includes the
  cartridges and their replacement?
• Should we define a separate market for cartridges
  (implying that there is a separate market for
  every brand and that each firm has monopoly power
  over consumers that have bought their brand)?

36
Example 2 Mobile telephony

• Retail and wholesale market
• Retail is where operators compete for clients
• Wholesale is where operators pay each other for
  terminating calls that originate on another
  network
• Is there a separate (wholesale - B2B) market for
  termination?
• Implying every firm has a monopoly position in
  its own termination market?
• Is it necessary to regulate this wholesale market?

37
Example 3 soft drinks delivery to bars

• Bigger firms like Coca-Cola supply soft-drinks to
  bars (wholesale market). A bar wants to have
  different soft drinks on offer. Coca-Cola and Ice
  Tea are complements for the bar (not for the
  final consumer)
• Is there a market for soft drinks?
• But Pepsi and Coke are probably also not
  complements for the bar .

38
Types of substitutes, differentiation

• Horizontal differentiation
• At equal prices, different consumers prefer
  different products
• Location (geography)
• Product characteristics
• Individuals (x) and products (?) have locations.
  Utility negatively depends on difference t(x -
  ?). The smaller t, the more the products are
  substitutes
• Vertical differentiation
• At equal prices, all consumers prefer better
  product. But consumer differ in terms of how much
  they are willing to pay for it. Utility x? p.

39
Firms influence market definition

• Product choice is endogeneous
• Firms strategically choose product / location
• Frequent flyer programmes tend to differentiate
  what in essence is a homogeneous product (KLM
  example)
• Firm conduct co-determines structure of the
  market. Thus, reverse causality (SCP paradigm)

40
Concluding

• Reviewed basic microeconomic notions
• Standard monopoly behaviour
• Perfect competition
• Welfare evaluation
• Provided broad outline of rest of the course
• Different aspects of monopoly behaviour
• Different aspects of price competition
• Entry deterrence
• Mergers, Collusion, etc.