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Summary Industrial Organization Essay

A perfectly competitive industry has 6 main characteristics: 1) large number of buyers and sellers 2) producers and consumers have perfect knowledge 3) the products sold by firms are identical 4) firms act independently and aim at maximizing profits 5) no entry or exit barriers 6) firms can sell as much output as they want at the current market price NEOCALSSICAL THEORY: Static conception, focus on long-run According to Schumpeter and the Austrian School, the fact that a firm earns an abnormal profit (monopoly) profit does not constitute evidence that the firm is guilty of abusing its market(monopoly) power at the expense of consumer: entrepreneur, creative destruction monopoly status is only a temporary phenomenon competition is a dynamic process Disequilibrium reflects imperfect information or ignorance on the part of buyers and sellers!!

Structure-Conduct-Performance (SCP) Paradigm Structure is the central element. It influences conduct which in turn has an effect on the performance STRUCTURE Number and size of firms, entry conditions, product differentiation, vertical integration, diversification; fixed int he short-run CONDUCT Business objectives, pricing, design and branding, advertising and marketing, R&D, collusion, merger; refers to the behaviour of a firm PERFORMANCE Profitability, growth, quality of products and services, technological service, productive and allocative efficiency; Chicago School about abnormal profit: causes may be cost advantage and superior efficiency

STUDY CASE: EUROPEAN BANKING To prevent from damaging implications for consumer welfare, there can be interventions of the government. The government policy is regulatory intervention to promote competition and prevent abuses of market power preventing a horizontal merger, break up of a large incumbent producer price controls, punishment of unlawful collusions

The Chicago School is a group of prominent academic lawyers and economists, whose promarket, pro-competition and anti-government views were perhaps of their most influencial during the 1970’s and 80’s Critics of the SCP Paradigm the theory does not always specify precise relationships between S, C, P variables it is often difficult to decide which variables belong to which category performance is only some measure of the degree of success in achieving desired goals the definition of market or industry structure has a number of dimensions danger of overemphasizing the role of concentration little comprehensive information is available on more subtle aspects of market structure and essentially no systematic data aside from accounting profit rates is available on conduct and performance relationships are oftein quite weak in terms of statistical significance no explanation is offered as to the evolution of the market structure variables, and the influence of the current conduct and performance on future structure according to the collusion hypothesis, a positive association between concentration and profitability was interpreted as evidence of collusion or other abuses of market power designed to enhance profit according to the efficiency hypothesis (Chicago), a positive relationship between concentration and profitability reflects a natural tendency for efficient firms to be successful and to become dominant in their industries Strategic management: 5 forces model

1) Extent and intensity of competition 2) Threat of entrants 3) Threat of substitute products and services 4) Power of buyers 5) Power of suppliers Porter’s approach: static, underemphasises the problem of uncertainty caused by change in the competitive environment, competitive advantage is measured by the value the firm is able to create in excess of its costs, Porter introduces the concept of the value chain, which disaggregates the firm into its strategically relevant activities:

Primary activities (physical creation of produt/service), Support activities (support primary activities and each other) each activity is linked to another, this approach examines how these links can be improved in order to increase margins on each of the firm’s products Kay argues that each individual firm is inherently different, and therefore dismisses the notion of generic strategies. Instead, firms develop distinctive capabilities in an ettempt to achieve competitive advantage. This shift away from analyzing the characteristics of the environment, and towards examining each firm’s unique attributes strategies mirrors the shift of emphasis away from structure and towards conduct that is imlicit in much of the NIO literature.

Sources of distinctive capabilities: Innovation, architecture, reputation determinants of performance Firms can only maintain a competitive advantage if they can protect their strategies from imitation The strategic management approach has been criticized for placing insufficient emphasis on the interaction between firms at the level of the market or industry. Instead, the focus is mainly on strategic options available to the firm. • Chapter 2: Microeconomic foundations: The short-run relationships between inputs, outputs and production cost is governed by the law of diminishing returns, and the long-run relation is governed by economies or diseconomies of scale!! The Production Function: q=f(L,K) inthe short run labor is variable but capital is fixed!!!

Law of Diminishing Returns: As increasing quantities of labor are used in conjunction with a fixed quantity of capital, eventually the additional contribution that each successive unit of labor makes to total output starts to decline Marginal Product of Labor (MPL): It is the qunatity of additional output the firm obtains by employing an additional worker. Average Product of Labor (APL): It is the ratio of total output to quantity of labor employed. It is important to notice that APL is increasing whenever MPL>APL and APL is decreasing when MPL2f(L,K) f(2L,2K)=2f(L,K) f(2L,2K)1 price elastic sensitive quantity PED =1 unit price elasticity PED 0 for substitutes, 2: more weight to larger firms if for above average performers. • Business unit effects > form low performers o The new empirical industrial organization. The new empirical industrial organization shifts the focus from structures analysis to conduct analysis. It is grounded firmly in microeconomic (oligopoly) theory. NeIO makes direct observations of conduct in specific industries, and draws inferences about what these observed patters of conduct might mean for structure.

The Rosse-Panzar revenue test is based on empirical observation of the impact on firm-level revenues of variations in the prices of the factors of production that are used as inputs in the production processes of a group of competing firms. The H-statistic is defined as sum of elastic ties if a firm’s total revenue w.r.t. each of its factor input prices. It differs under perfectly competitive, imperfectly competitive and monopolistic market conditions. See page 336 for graphs. If H = 1 conduct perfect competition If H < O conduct monopoly If 0 < H < 1 conduct imperfect competition Empirical evidence: • Commonly, price-setting behaviour in accordance with intermediate competition models is detected. Limits: • Offers a determination of only what the market structure of degree of monopoly is not, and does not suggest what it is.

o The persistence of profit

Persistence of profit approach examines the time-series behaviour of firm-level profit dates. It suggest: profitability in more profitable industries tends to fall and profitability in less profitable industries tends to rise. tendency for profit rates to converge. supports the disequilibrium hypothesis. Firm level studies suggest there are significant differences between firms in long run equilibrium profit rates, and differences in the speed of convergence. Industry level studies: • If current profitability is higher than expected, entry should take place causing profitability to fall and v. v. the empirical results suggest the process of adjustment towards l.r. equilibrium takes about four years. Industry level variables such as entry barriers, concentration and growth in demand determine the speed of adjustment.

There is evidence of a tendency for profitability to persist, especially in highly concentrated industries. • Firm level studies: o If competition is anything less then perfect, and there are barriers to entry, it may take some time for any abnormal profit to be eroded. s.r. profit persistence. o L.r. profit persistence: where there are barriers to entry, there no convergence of firm level rates towards a common l.r. average value. If some firms posses and are able to retain specialized knowledge or other advantage, theses firms may be able to earn profits that remain above the norm persistently, in the long run. o L.r. persistence refers to the degree of variation between firms in the l.r. average profit rates no convergence (empirical result)

Part 3: analysis of firm strategy:

• Chapter 10: Pricing: o Critic of neoclassical theory: do firms have enough information to apply the profit maximization rule MR = MC? o Cost plus pricing Under cost plus pricing, the firm calculates or simply estimates its AVC and then sets it price by adding on a percentage mark-up that includes a contribution towards the firm’s fixed costs and a profit margin. P = (1+m)AVC This is simple to understand and can be implemented using less information. AVC is relatively flat over a relevant range of output levels; minor variations in the level of demand need not lead to changes in price. So it reduces consumer’s search costs and also reduces destructive price competition. The mark up determination appeals to a sense of fairness. Otherwise it is not simply implemented for a multiproduct firm. The wide-spread use of cost plus pricing might suggest it as a convenient rule of thumb form firms that are really profit maximizers-

cost plus pricing is equivalent to profit maximization pricing if AVC is approximately constant, and the mark up is set to a value of 1/(PED/1). Research showed that firms where more profit oriented where competition was more intense and also large firms turned out to be more likely profit maximizing. o Price discrimination A firm that enjoys some degree of market power might consider adopting a more complex pricing policy, for example to sell at different prices to different consumers. First degree price discrimination: • Perfect price discrimination involves making the price per unit of output depend on the identity of the purchaser and on the number of unit purchased. Second degree price discrimination: • Involves making the price per unit of output depend on the number of units purchased. Third degree price discrimination: • Involves making the price per unit depend on the identity of the purchase.

The term dumping describes the practice of charging a lower price to consumers in poorer countries than to charge in richer countries. Two conditions: • Some degree of market power and the market has to be divisible into sub-markets different demand conditions, no trade or resale, significant transport costs can also help to achieve an effective physical separation of sub-markets. First degree: • Each consumer’s reservation price is the max. price the consumer is willing to pay. The monopolist can exploit the differences in willingness to pay by charging each consumer high or her own reservation price. It is worthwhile for the monopolist to supply all consumers whose reservation price exceeds the monopolists marginal costs. It is also possible that if reductions in the prices of further units are offered, that the consumer is induced to buy three, four … units.

Another way to abtain surplus is to charge a two-part tariff: uniform additional price + fixed fee. In this form of pr. Discr. Producers earn an abnormal profit, there is no CS and there is no DWL. It is known as perfect price discrimination because all the available surplus is extracted by monopolists. • Page 360 Second degree: • In the case where the monopolist cannot distinguish between consumer, the best policy is to offer the same menu of prices and quantities to all and allow the consumers to self select. • Page 362 • If the monopolist sets a fixed fee slightly lower than PCAF, and charging a uniform price per unit slightly higher than PC, he can gain additional PS • With Pc + P the fixed fee is reduced from WXY to W.

Here the producer cannot extract all of the surplus. So first degree price discrimination (perfect information about consumer preferences) is more profitable than second degree (imperfect information) Third degree: • Here the price per unit that each consumer pays is constant, but the monopolist can segment the market by offering different prices to different consumers. Partial market segmentation is achieved through age, membership, gender, profession etc. • The monopolist should select the price quantity combination for each sub-market at monopolistic output. • One price will always be higher and the other price lower than the uniform monopoly price in the non discriminating case. Consumers in the sub market with the lower price have more CS and are always better off than in the non-discriminating case.

• Examples: o With intertemporal price discrimination, the supplier segments the market by the point in time at which the product is purchased by different groups of consumers. Each consumer is willing to make his purchase in one of the two periods. (page 369). But: Coase: consumers may learn that prices will be cut and wait with purchasing. o Brand labels: do not really represent pr. Discr. More products are different because of genuine product characteristics. o Loyalty discount: 2nd degree pr. Disc. o Coupons: some from but connected with effort o Stock clearance: some form o Free on board pricing same prices neglecting different costs in different areas. o Peak-load pricing Much of the theoretical literature on peak load pricing is based on an assumption of social welfare maximization.

When a peak-load pricing problem exists, often capacity cannot be adjusted. Page 372 The optimal price for each period is the total marginal cost incurred through the installation of additional capacity and the additional production in both periods minus the price charged in the other period. The peak-period consumers, whose demand or willingness to pay is stronger are charged a higher price than the off-peak consumers. MC of installing additional capacity is lowered to B’. Chapter 11: Auctions: o Auction formats, and models of bidder valuation An auction is a market mechanism for converting bids from market participants into decisions concerning the allocation of resources and prices, though a specific set of rules. price formation under conditions of uncertainty, asymmetric information and interdependence. There are four basic auction formats providing the cornerstone for the economic theory of auctions.

The English auction (ascending bid auction) involves the price being set initially low and then raised successively until a level is reached which only one bidder is willing to pay. The Dutch auction (descending bid auction) works in the opposite way. In the first price sealed bid auction, each bidder independently submits a single bid, without seeing the bids submitted by other bidders. The highest wins and pays. The second price sealed bid auction (vickrey auction) works similar as the first prices sealed bid auction, but here the highest bidder gets the item and pays a price equal to the second highest bid. Asymmetric information means that seller and buyers typically do not have perfect information concerning the distribution of bidders valuations of the item being auctioned.

There are also two alternative assumptions: • In the pure common value model, the item is a single, intrinsic value that is the same for all bidders, but nobody knows the true value. • In the independent private values model, each bidder knows the true value of the item to himself personally. no single value • The affiliated valuation model includes elements of both. o The pure common value model and the winner’s curse The winner’s curse appears to be a rather common feature of many auctions in which bidders valuations conform to the pure common value model. It is very likely that the winning bidder, with the highest private estimate has overvalued the item. The winning bidder is very likely to turn out to be a loser, in the sense of having overpaid the item.

Two possible estimates of the true value: a) original private estimate unconditional. b) revised estimate (knowing other valuations) conditional. In order to avoid the winners curse, the sealed bid should be based on a revised estimate, conditional on the bidder’s original estimate being the highest estimate. In fact, in a first price sealed bid auction, it pays to submit a bid some distance below the bidders opinion as to the true value. o Optimal bidding strategies and revenue equivalence in the independent private values model. Assumptions: private values are randomly drawn from a uniform distribution. Risk neutrality of the bidders.

The English auction: • Withdraw as soon as the price equals or exceeds the private value. You gain a rent equal to the difference between private value and winning bid, or nothing. Second price sealed bid auction: • A bidder’s optimal bidding strategy is to enter a bid equivalent to his or her own private value. By raising your bid, you can only lose, you cannot possibly gain. The rival’s bid determines the price you would have paid if you had bid your private value. Therefore by lowering your bid you have forfeited an opportunity to buy the item for less than your private value. • English and second price auctions can be described as strategically equivalent when everybody behaves rationally. In the terminology of game theory it is in both cases a dominant strategy.

First price sealed bid auction: • It pays to submit a bid that is below your own private value. • Page 396: o P(0) = 0 o P(B) is and increasing function of B. The higher the bid, the higher P(B) to win. o P(B) is a decreasing function of l. The higher the number of bidders, the lower P(B) to win. • By reducing the submitted bid below BH =Vi, bidder i gains by committing to pay a lower price, but also loses by accepting a lower P(B) of winning. The position of the P(B) curve depends on the bidding strategies of the bidders. • Nash equilibrium’s optimal bid: ((N-1)/N) * Vi • As the number of N increases, the optimal bid approached the bidder’s private value. Dutch auction: • Wait until the price has fallen a certain amount below the private value. gain a positive rent. By allowing the price to drop, you can only gain and you cannot lose. Bidder I should bid when the price reaches ((N-1)/N) * Vi. So, also the two last auctions types are strategically equivalent.

The revenue equivalence theorem: • All four auctions formats are expected to yield exactly the same price to seller on average. The seller is expected price is always the expected value or expectation of the second highest private value (page 399). Sellers expected proceeds: o E(V2) = (N-1)/(N+1) • It is important to remember that the revenue equivalence theorem relies heavily on the independent private values assumption. Evidence is rather limited o Extensions and additional topics in auction theory. To ensure a certain price for the seller, he can introduce a rule that the item is not sold if the price payable by the winning bidder does not at least match (or exceed) a reserve price. It can be shown that it is optimal for the seller to set a reserve price that is higher than his own private value.

Inefficient allocation of resources can be consistent with the maximization of the seller private proceeds. The optimal reserve price does not depend on the number of bidders. The price should not be too high, because then the item won’t be sold anymore. Risk averse bidders: • In an English auction, risk aversion makes no difference to the optimal bidding strategy. In a Dutch auction, in contrast, risk aversion causes the bidder to call out earlier. Therefore the revenue equivalence theorem breaks down if bidders are risk averse (Dutch auction yields higher profit for the seller). In a second price auction, risk aversion causes nothing to change. In a first price sealed bid auction, risk averse bidders tend to bid closer to their private values than risk neutral bidders theorem brakes down again.


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