Introduction to Industrial Organization
Lecture 2

Introduction

1. Four market structures

1. Pure Competition - accepts the market price in order to sell their products. They are also called price takers

   • All firms produce an identical product (homogeneous)

     • Consumers do not care where they buy the product

   • Many sellers and buyers are in the market

     • Each firm supplies only a small portion to the market

     • One firm cannot influence the price of the market

   • No barriers to entry or exit exist

     • Drives model

     • Profit - firms enter market

       • Supply function increases

       • Market price decreases

       • Stops when firms breakeven

     • Losses – firms leave market

       • Supply function decreases

       • Market price increases

       • Stops when firm breakeven

   • Competitive markets do not have economies of scale

   • Information is perfect

     • Consumers are aware of alternatives

     • Firms informed about production possibilities

   • The firms maximize profit by adjusting production level, but cannot influence market price

   • Examples: Agricultural markets, retail, some service markets, and stock markets

2. Monopolistically Competition - similar to a purely competitive market, but firms have a touch of monopoly power

   • Called a price searcher

   • Many firms in market, but not as many as pure competition

     • Producers are independent

     • Collusion is not possible

   • Low entry barriers

     • If one firm earns economic profit, then new firms enter the market

   • Produce differentiated products (heterogeneous)

     • Gives a little monopoly power

     • Face a downward sloping demand curve

     • Different from competitors' products

   • Nonprice competition - compete in other areas other than price

     • Product quality - physical or qualitative differences

       • Sony TV vs. Goldstar TV

     • Services - condition surrounding the sale of a product

       • Friendly sales clerk

     • Location and accessibility

       • Gas station versus store, when buying Pepsi

     • Promotion, packaging, and brand names - imaginary or real differences in quality

       • Exampld - Clorox is very successful in marketing its bleach although it is the same chemical

     • Use advertising to create differentiated product

3. Oligopolies - few sellers in a market

   • Strategic behavior or interdependence – a firm has to consider the competitors, when deciding prices, production level, or product quality

     • The rival firms react to the firm's decision

     • Game theory

   • Mergers - a firm can buy other firms and combine them into one company

     • Firm controls a larger market share and could gain more monopoly power

   • Oligpopolies have entry barriers

   • Products may be identical (homogeneous) or differentiated

     • Identical products - milk, cement, gasoline, etc.

     • Differentiated products - sodas, shoes, computers, etc.

   • Use product style, quality, and advertising

   • Examples: Automobiles, steel, pharmaceuticals, breakfast cereals, soft drinks, and beer

   • U.S. beer industry

     • In 1947, beer industry had over 400 independent breweries

     • In 1967, there were 124 suppliers

     • In 1980, there were 33

     • Currently, four brewing companies dominate the U.S. market

       • Anheuser-Busch - 49% of market

       • SABMiller - 20% of market

       • Coors Pabst

• Demand for a firm's product is d, because d is a fraction of the market

3. Monopoly - a firm is sole producer / supplier of a product in the market

   • Single seller of a product

     • The demand for the monopolist's product is the market demand curve

     • A one firm industry

   • No close substitutes for the product

     • You either buy the product from him or you don't

   • A monopolist can exert control over the price

     • He decreases production level and market price increases

     • Other firms are prevented from entering the market, because of high barriers

     • No competition

   • Could earn long-run economic profits

   • Examples: public utility companies, electricity, telephone, water, and natural gas

   • Monopoly – demand for monopolist's product is whole market

2. Two Schools of Thought for Industrial Organization

1. Structural-Conduct-Performance (SCP) Approach

   • Direct relationship between market structure, market conduct, and market performance

   • Pure competition is allocative efficient, P = MC

     • Market price equals marginal cost (MC)

     • Marginal cost is the change in production if the firm changes production by one unit

     • Consumers determine market price

     • Firms determine marginal costs

     • Thus, long-run profits are driven to zero

   • Monopoly is allocative inefficient, P > MC

     • Could earn long-run profits

   • Oligopolies could have P > MC

     • Use advertising to promote brand

     • Creates entry barrier

     • Potential competitors may not have advertising funds to enter market

2. Chicago School of Thought

   • Use price theory models to analyze markets

   • Examples

     • SCP approach - monopoly power leads to increase in profits

     • Chicago - increased efficiency led to increased market power, and increased profits

     • SCP approach - advertising costs creates entry barriers, enhancing profits

     • Chicago - advertising provides information; better information leads to lower prices

3. Both schools of thought are used to explain a firm's behavior

3. Market structure affects firm's behavior

• Firms strive to become monopolies

  • Drive competitors out of business

• Monopolies/oligopolies prevent entry of new firms

  • Erect market barriers

• Market structure can change over time

• Market power – firm can influence market price

  • Pure competition – firms have no market power

  • Example: If firm raises price, the buyers buy from competitors

• Example: Monopoly can raise market price by reducing production or sales

  • Increase profits

  • Largest difference between P and MC, P > MC

4. Examples of market power

• Seller concentration – a measure of size distribution and of number of firms

  • Computer operating systems

    • Microsoft 90%

    • Apple Operating System

    • Linux and its variants are free

  • Fast food places are on every street corner

• Economies of scale – a firm has to be large to supply product cheaply

  • Example – new microprocessor

  • Intel spends $3 billion of a new facility

    • Intel 81.5%

    • AMD 17.8%

    • VIA (C7/Nano)

• Brand proliferation – company’s products take up shelf space

  • New firm has trouble entering the market

• Product differentiation – leads to nonprice competition

  • Products are similar but not perfect substitutes

  • Location, types of sales clerks, etc.

• Product specification – company wants to establish standards

  • Enhances profits

  • Example: Video tapes

    • Sony – Beta

    • JVC – VHS

    • VHS became a standard

  • Note – computer media has formats

    • Music – MP3, WMP

    • Videos – DivX, DivD, DVD, etc.

• Regulations – some industries are heavily regulated while others are not

  • Utility industry – electricity, water, natural gas are heavily regulated

  • Gov. regulated prices, profits, and production, including which technologies

5. Government

• Before the U.S. Civil War (1860 - 1864)

• United States was an agrarian society

  • High transportation costs

  • Local markets

  • Small firms

• After the Civil War

  • Railroad companies connect markets by railroad

  • Large capital markets formed

  • Markets became international

  • Companies became incorporated

    • Have economies of scale

    • Monopolies began to form

    • Monopolies put local companies out of business

• U.S government passed the Sherman Act

  • Gov. corruption was severe during this time

  • Gov. may fine or incarcerate anyone who "monpolizes"

  • Monopoly is not illegal, but only the behavior to use monopoly power

• U.S. laws evolved

  • Antitrust laws

    • Trust means a corporation president controls other corporations

    • U.S. government has the power to breakup monopolies

    • U.S. government can approve mergers

  • Government can regulate monopolies and set price

• Book lists many laws

  • I am not big on the law, especially U.S. laws

  • Lawyers are experts at manipulating laws