MICROECONOMIA II

Gonzalo Escobar E.
Semestre 202120
Facultad de Economía y Negocios
Universidad Andrés Bello
Industrial Organization:

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Introduction
• WHAT is Industrial Organization
• Study of 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
• Industrial Organization takes a Strategic view of
how firms interact

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 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
• Measure scale economies
• for entry deterring actions
• Experiment with penalty for price-fixing
• Examine the impact of advertising

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 Motivation for Industrial Organization Study
• WHY do Industrial Organization?
• Long-standing concern with market power
• Sherman Antitrust Act (Standard Oil)
• Need for anti-trust policy recognized by Adam Smith
• “The monopolists, by keeping the market constantly understocked,
by never fully supplying the effectual demand, sell their
commodities much above the natural price.”
• “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

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Motivation for Industrial Organization Study 2
• Sherman Act 1890
• Section 1: prohibits contracts, combinations and conspiracies
“in restraint of trade”
• Section 2: makes illegal any attempt to monopolize a market
• 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”

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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)

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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)

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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)

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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

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Basic Microeconomics

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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
• example: given an initial distribution of food aid will
trade between recipients improve efficiency?

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• Profit Maximization: the Basics

• Focus on profit maximizing behavior of firms

• Take as given the market demand curve
$/unit Maximum willingness
to pay
Equation: A
Constant
P = A - BQ
linear P1 slope
demand

• Importance of: Demand

– time
– short-run vs. long-run
– willingness to pay Q1 A/B Quantity

At price P1 a consumer
will buy quantity Q1

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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

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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

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 Perfect competition: an illustration

With market demand D2

• The supply curve moves to the rightWith
(a) The Firm andmarket
(b) The marketdemand
Industry supplyDS11
With market price PC • Price falls and market supply
equilibrium S1P
price is 1
$/unit $/unit equilibrium price
• Entry continues while profits exist and quantity is Q1Cis P
the firm maximizes Now assume that
profit by setting and quantity is QC
•Existing
Long-runfirms
MC maximize
equilibrium is restored demand
MR (= PC) = MC and atprofits
price Pby
C and supply curve S2
increasing increases
S1 to
D1 D2
producing quantity qc output
AC to q1

P1 P1 S2
Excess profits induce
PC new firms to enter
PC
the market
D2

qc q1 Quantity QC Q1 Q´C Quantity

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Perfect competition: additional points

• Derivation of the short-run supply curve

• this is the horizontal summation of the individual firms’
marginal cost curves

$/unit Firm 3
Firm 1
Example 1: Three firms
Firm 2
Firm 1: qMC
= MC/4
= 4q +- 82
q1+q2+q3
Firm 2: qMC
= MC/2
= 2q +- 84
Firm 3: MC
q = MC/6
= 6q +- 84/3
Invert these
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Aggregate: Q= q1+q2+q3
= 11MC/12 - 22/3
MC = 12Q/11 + 8 Quantity

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 Perfect Competition: Additional Points 2

Example 2: Eighty firms $/unit Firm i

Each firm: qMC

= MC/4
= 4q +- 82

Invert these

Aggregate: Q= 80q
Aggregate
= 20MC - 160
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MC = Q/20 + 8

• Definition of normal profit

– not the same as zero profit Quantity
– implies that a firm is making the market return on the assets
employed in the business

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 Monopoly
• The only firm in the market
• market demand is the firm’s demand
• output decisions affect market clearing price

At price P1
consumers Marginal revenue from a
$/unit
buy quantity Loss of revenue from the change in price is the
net addition to revenue
Q1 reduction in price of units
currently being sold (L) generated by the price
P1 change = G - L
L Gain in revenue from the sale
P2 of additional units (G)
At price P2
consumers G Demand
buy quantity
Q2 Q1 Q2 Quantity

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 Monopoly 2
• 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

Demand
revenue curve is also linear with
the same price intercept
but twice the slope of the demand Quantity
curve MR

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

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Market Structure and Market Power

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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

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 Measure of concentration
• Compare two different measures of concentration:

Firm Rank Market Share Squared Market

(%) Share
1 25 25 625
2 25 25 625
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

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Concentration index is affected by, e.g. merger

Firm Rank Market Share Squared Market

(%) Share
1 Assume that firms
25 25 625
Market shares
2 4 and 5 decide
25 25 change 625
to merge
3 25 25 625
4 5 5
} } 10
25
} 100
5 5 25
6 5 25
The Concentration
7 Index5changes 25
8 5 25

Concentration Index CR4 = 80 85 H = 2,000 2,050

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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?

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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)

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 Market definition 3
• 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

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 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?

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 Market definition 5
• 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

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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

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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

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Market Performance 2
• 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

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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

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Empirical Application: How Bad is Market Power Really?
• Harberger (1954) exercise: Welfare Loss (WL) is:
1
WL = 2 (P – MC)(QC – Q)
• Welfare Loss in relation to sales:
WL = 1 (P – MC) (QC – Q)
PQ 2 P Q
• This can be expressed as:
WL = 1  (LI)2
D
PQ 2

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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

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How Bad is Market Power Really? 3
• One problem is cost, possibly due to how advertising is
treated (P – MC) 2
WL
= 12 D
PQ 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

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Fast-Food Outlets

McDonald Burger Wendy’

’s King s

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