Industrial Organization, Defined Industrial Organization: The study of the

structure of firms and markets and of their interactions.

Market Structure - the particular environment of a firm, the characteristics of which influence the firm’s pricing and output decisions.

The continuum of market structuresPerfect competition -------------------------------

Monopoly The study of perfect competition and monopoly

provides the extremes, so we can see the limits of what is possible.

Structure-Conduct-Performance

Structure – Rules of the Game Concentration Measures

Conduct – How the Game is Played Pricing, Integration, R&D, Advertising

Performance – Outcome of the Game Profits, Social Welfare

Seller Concentration Measures n-firm concentration ratio Herfindahl-Hirschman Index Rothschild Index Lerner Index

n-firm concentration ratio

Sales of top n firms / Sales in the industry Examples

C4 = Sales of top 4 firms / Sales of industry C8 = Sales of top 8 firms / Sales of industry

Herfindahl-Hirschman Index

HHI = 10,000 * Σwi2

Where, w = market share Note: If one measures market share

in whole numbers (i.e. 10% is 10), then one does not need to multiply by 10,000

Purpose: The HHI is designed to capture asymmetries in competition.

Interpretation of HHI

Interpretation of HHI with respect to mergers If HHI < 1,000 after merger; no action taken If HHI > 1,000 but less than 1,800, Justice

Department will generally consider action if HHI rises by more than 100.

If HHI > 1,800 the merger is generally blocked if the HHI rises by more than 50.

Rothschild Index

Rothschild index - a measure of the sensitivity to price of a product group as a whole relative to the sensitivity of the quantity demanded of a single firm to a change in its price.

R = ET / EF (Ratio of elasticities in absolute terms) Why is this a concentration ratio? One must note that sales at

the industry level will be less responsive to price than sales at the firm level. The closer the firm is to being the industry, the less the difference between the elasticity of the industry and elasticity of the firm.

Rothschild index is bound between (0,1). Closer to 1 the more concentrated an industry probably is.

Limitations of Concentration Ratios Industry definitions and product classes National markets (proper geographic

definition) Global markets (impact of imports and

exports) Each of these can be overcome by the

cross-price elasticity.

Lerner Index

Lerner Index (Measure of Inequality)L = (p - MC)/pLerner Index is bound between (0,1)Closer to 1 the more pricing power the firm has.Why is this a concentration ratio?Mark-up power reflects monopoly power.

The work of Matthew Shapiro

Rothschild Lerner

Food 0.26 0.26

Apparel 0.27 0.24

Textiles 0.32 0.21

Leather 0.52 0.43

Publishing 0.56 0.31

Rubber 0.78 0.43

Paper 0.88 0.58

Petroleum 0.88 0.59

Chemicals 1.00 0.67

Tobacco 1.00 0.76

Product Differentiation

Products are different if there is some objective characteristic or property, real or perceived, that provides a basis for buyers to choose one over the other.

Product differentiation may lead to reduced own -price elasticity. As the degree of differentiation increases, the price elasticity will decrease.

Demonstrate graphically and mathematically the impact product differentiation has on own-price elasticity.

Perfect Competition & MonopolyDefinitions

Perfect Competition – A market structure characterized by a large number of buyers and sellers of an identical product.

Monopoly – A market structure characterized by a single seller of a highly differentiated (unique) product.

Price Taker vs. Price Maker

Price Taker – Buyers and sellers whose individual transactions are so small that they do not affect market prices.

Price Maker – Buyers and sellers whose large transactions affect market prices.

NOTE: Being a price maker does not mean you can charge any price you like.

Factors that Determine the Level of Competition

1. Product differentiation (real or perceived differences in the quality of goods and services).

2. Size of the market relative to MES.3. Barriers to entry and mobility.

a. Barriers to entry – any advantage for industry incumbents over new arrivals.

b. Barriers to mobility – any advantage for leading firms over small non-leading rivals.

c. Barriers to exit – Any limit on asset redeployment from one line of business or industry to another.

Perfect CompetitionCharacteristics

1. Large number of buyers and sellers.

2. Product homogeneity.

3. Free entry and exit.

4. Perfect dissemination of information.

5. No transaction costs

Perfect CompetitionShort Run vs. Long Run

In the short-run economic profit (or loss) is possible.

In the long-run, competitive pressures will cause the typical firm to earn zero economic profits.

NOTE: UNDERSTAND THE MATHEMATICS OF PERFECT COMPETITION IN THE SHORT-RUN AND THE LONG-RUN.

MonopolyCharacteristics

1. A single seller.

2. Unique product.

3. Blockaded entry and exit.

4. Imperfect dissemination of information.

NOTE 1: Monopoly power can exist without these

conditions being exactly met.

NOTE 2: UNDERSTAND THE MATHEMATICS OF MONOPOLY IN THE SHORT-RUN AND THE LONG-RUN.

Monopoly Myths Myth one: Monopolies can

charge whatever price they wish. A monopoly is constrained by its level

of demand. Myth Two: A monopoly always

makes an economic profit. If demand is insufficient, P < ATC, and

the firm will not make an economic profit.

If all monopolies made an economic profit, each small town would have the same assortment of goods and services offered in a larger city.

Monopoly vs. Perfect Competition

In perfect competition: P = MR = MC In monopoly: P > MR

P > MCMR = MC

So a monopoly does not produce the good according to the dictates of resource allocative efficiency.

In perfect competition in the long-run: P=MC=ATC

In monopoly: P may exceed ATC indefinitely.

So a monopoly does not produce the good according to the dictates of productive efficiency.

Willingness to Pay – the maximum amount that a buyer will pay for a good.

Consumer Surplus – a buyer’s willingness to pay minus the amount the buyer actually pays.

Use the demand curve to measure consumer surplus.

NOTE: Consumer surplus measures the benefits that buyers receive from a good as the buyer themselves perceive it.

Consumer Surplus

Cost – the value of everything a seller must give up to produce a good.

Producer Surplus – the amount a seller is paid for a good minus the seller’s cost.

Using the supply curve to measure producer surplus.

Producer Surplus

Social Costs of Monopoly

Deadweight Loss [Illustrate] Given P = $600 - $2Q

TC = $500 + $100Q + $3Q2

What is the deadweight loss created by a monopoly?

1. Determine monopoly output (MR = MC).2. Determine monopoly price.3. Determine marginal cost at the monopoly

output.4. Determine perfectly competitive output

(P=MC).5. Determine deadweight loss.

Measuring the Inefficiency of Monopoly Power

Dansby-Willig Performance Index - Ranks industries according to how much social welfare would improve if the output in an industry were increased by a small amount.

If DW = 0 , Social welfare would not be improved if industry output was expanded.

If DW > 0 , Social welfare would be improved if industry output was expanded.

BE ABLE TO SHOW GRAPHICALLY (WE ARE NOT ACTUALLY CALCULATING THIS MEASURE)

Other Social Costs

Rent-seeking - actions of individuals and groups who spend resources to influence public policy in the hope of redistributing income to themselves from others.

X-inefficiency Price discrimination - to charge

different prices to different individuals or groups of individuals

Monopolistic Competition

Monopolistic Competition – A market structure characterized by a large number of sellers of differentiated products.

1. Large number of buyers and sellers.

2. Product heterogeneity.3. Free entry and exit.4. Perfect dissemination of

information.

Monopolistic CompetitionShort Run vs. Long Run

In the short-run economic profit (or loss) is possible.

In the long-run, competitive pressures will cause the typical firm to earn zero economic profits.

More on Monopolistic Competition

Although economic profit is zero (P=ATC), price is still greater than marginal cost.

Product differentiation results in a downward sloping demand curve.

Consequently, price exceeds marginal revenue. WHY?

To profit maximize MR = MC, therefore price exceeds marginal cost.

Even More on Monopolistic Competition

If P = ATC and P > MC, then ATC > MC. What does this mean? A firm in monopolistic competition does not produce at capacity (i.e. it is not as efficient as perfect competition).

Is this a social cost? Is product differentiation worth inefficient production?NOTE: UNDERSTAND THE MATHEMATICS OF MONOPOLISTIC COMPETITION IN THE SHORT-RUN AND THE LONG-RUN.