Industrial Organization PDF

General Introduction................................................................................................................................. 1 Markets and market power.................................................................................................................... 1...

General Introduction................................................................................................................................. 1 Markets and market power.................................................................................................................... 1 Markets.............................................................................................................................................. 1 Our main focus.................................................................................................................................. 1 How do markets OPERATE?............................................................................................................... 1 Market power..................................................................................................................................... 2 Running story..................................................................................................................................... 2 GENERAL INTRODUCTION MARKETS AND MARKET POWER MARKETS Markets allow buyers and sellers to exchange goods and services in return for a monetary payment and play a central role in the allocation of goods. The existence and structure of markets also impact production decisions. Industrial Organization is the branch of microeconomics that studies the role of imperfectly competitive markets in private and social decisions. We examine the interaction between markets and strategies, focusing on “market power”. Many different types of markets: Farmers’ goods (local) VS Passenger jets (global) Computer software (product) VS Software support (service) Electricity (homogeneous product) VS Specialized steel (differentiated product). DVDs (offline) VS Video streaming (online), which can exist in physical or virtual space. OUR MAIN FOCUS In oligopoly markets, a small number of sellers set price, quantity, and other variables strategically, while a large number of buyers react non-strategically to supply conditions, acting as price takers. marché public In some procurement markets, the structure is reversed, with a small number of buyers facing a large number of sellers. While most examples focus on markets where buyers are final consumers, this analysis also applies to markets involving small retailers, service providers, or manufacturers. The investigation addresses characteristics shared across different market types, whether the buyers are final consumers or intermediate actors like businesses. HOW DO MARKETS OPERATE? In perfectly competitive markets, both buyers and sellers are price-takers, which is common in industries with low entry barriers and a large number of small firms. However, we focus on markets where firms possess market power, allowing them to set prices above marginal cost without losing all demand. superieur Market power applies not only to large firms but also to smaller ones, and understanding its sources and effects is central to the course. MARKET POWER Market power refers to a firm's ability to raise prices above marginal cost without losing supernormal profits to new entrants. In contrast to highly competitive markets, firms with market power can set higher prices and maintain profits. They achieve this by using barriers to entry that prevent new firms from entering the market. When only a few firms hold considerable market power, the market is described as an oligopoly, where power is highly concentrated. In a competitive market, firms typically set prices close to their marginal cost (the cost of producing one additional unit). However, a firm with market power can set prices higher than the marginal cost. A competitive market is characterized by a large number of buyers and sellers, homogeneous products, free entry and exit, perfect information, and the absence of individual market participants with significant influence over prices. In a competitive market, firms are price takers, meaning they accept the market price and cannot independently set prices. Market power is not always bad, it’s only bad when it is abused Good thing o Market power can be seen as a reward for aggressive competition. In other words, firms that actively compete and outperform others may gain market power as a result o Market power can stem from positive factors such as innovation, the introduction of a novel business model, or more efficient operations. Bad thing o Market power becomes problematic when it is "abused." This typically refers to situations where dominant firms are engaged in strategies that harm competition and consumers. Strategies used by dominant firms in a market to enhance or protect their market power. améliorer renjouer ,  ▪ “Abuses of dominance”, “anticompetitive strategies”, “monopolization” Strategies used to maintain or enhance market power can have negative consequences. o These consequences may include harm to consumers and broader economic damage préjudier POTENTIAL EXAM QUESTION Which authority is responsible for competition policy (i) at the Belgian level, (ii) at the European level, (iii) in the United States? Competition policy Belgian level: The Belgian Competition Authority (BCA) is in charge of competition policy within Belgium. European level: At the European level, the European Commission oversees competition policy for all member states. United States level: In the United States, both the Federal Trade Commission (FTC) and the Antitrust Division of the Department of Justice handle competition policy, working to ensure fair competition in the U.S. market. MARKET PLAYERS CONSUMERS Our focus is on final consumers (although we also consider firms as intermediate consumers in some parts of the course). Final consumers are usually supposed to be rational and price-takers. Their decisions are then aggregated into demand functions. CONSUMER’ DECISION PROBLEM The consumers choose: Quantities of several good 𝑞 = (𝑞1, 𝑞2, … , 𝑞n) Quantity 𝑞₀ of the "Hicksian composite commodity": This represents all other goods not explicitly considered in the market being analyzed. Consumers make their choices one market at a time. While they may buy various goods (e.g., vegetables, chocolates, a car, or a fridge), we simplify the analysis by combining all goods other than the one of interest into a single composite commodity, referred to as 𝑞₀. This allows us to focus on the specific market (e.g., vegetables) while accounting for the broader range of goods in a simplified way. plus large Maximize quasi-linear utility: 𝑢(𝑞) + 𝑞0, under the budget constraint: 𝑝 ∙ 𝑞 + 𝑞0 ≤ 𝑦. budget It’s equivalent to: The solution to the FOCs provides individual demand functions. We are not only interested in individual demand; we want to understand the demand in the overall market we can go from individual to aggregate demand: Either any consumer is representative of all others, or account for taste differences among consumers. Example 1: Representative consumer (it’s the consumer that summarize all the consumers) Consumer chooses the quantities 𝑞1 𝑎𝑛𝑑 𝑞2 to maximise With 𝑞1 𝑎𝑛𝑑 𝑞2 2 different good, 𝑝1𝑞1 what we spend for the first good and 𝑝2𝑞2 what we spend fort the second good and finally 𝑦 the total budget of the consumer. FOC’s: So, the inverse demand (prices as a function of quantities) functions are: a is the maximum price consumer is willing to pay for each good b measures link between price and quantity of the same good d measures link between price and quantity of different goods → degree of product substitutability If d = 0 we have independent goods because term n°3 will be equal to 0 so 𝑝1 will be express only in terms of 𝑞1 and same for 𝑝2. If d = b we have homogenous goods (and 0 ≤ d ≤ b) Now that we have the inverse demand (quantity as a function of prices), we need to find the demand function. If we have homogenous goods so if d = b, we have 𝑝1(𝑞1, 𝑞2) = 𝑝2(𝑞1, 𝑞2) = 𝑝 = 𝑎 – 𝑏𝑞1 – 𝑏𝑞2 and the demand functions are: In this case, if good 1 is more expensive than good 2 (i.e., p1>p2), consumers will choose to only consume good 2. Example 2: Different consumers (we cannot summarize them as a unique person) Suppose that: 1000 potential consumers have a unit demand (means that the consumers are willing to buy one unit or zero, but they don’t have any utility for a second or third or four unit) for some product They buy either one unit or none (no utility for a second unit) Each consumer is characterized by her willingness to pay, v volonté Maximum price (‘paint touch’) that she is willing to pay for one unit of the product V is drawn from a uniform distribution on the interval [0,1] Each value has the same probability There is an equal proportion of consumers for each value If the price is p, consumers with value v buy if and only if v>=p The proportion of consumers with v>=p is equal to 1-p As there are 1000 consumers and each of them buy one unit, the total quantity demanded is 𝑞(𝑝) = 1000(1 − 𝑝) WELFARE ANALYSIS OF MARKET OUTCOMES The partial equilibrium focus on one market at a time and abstract away cross-market effects. Welfare measures Consumers: consumer surplus o Net benefit from being able to purchase a good or service o Difference between willingness to pay and price actually paid o Potential problems ▪ Income effects ▪ Extension to several consumers ▪ Extension to several goods Firms: sum of firm’s profits Example 1 of consumer surplus FOC’s: So, the inverse demand (prices as a function of quantities) functions are: By putting those results back in CS we have : The special case where d=b gives us: The consumer surplus is the triangle in blue (it’s the surface above the price we have). In most of the course, we will assume that consumers behave rationally. This assumption is a reasonable approximation in many situations, but not always (video explicative dans le cours). COGNITIVE BIASES Cognitive biases are like mental shortcuts that can lead people to make decisions that might not be entirely logical. These patterns of thinking are often influenced by our emotions or other psychological factors, and they can cause us to consistently make choices that aren't entirely rational. Nudge theory: Nudging involves subtly influencing people's behavior without restricting their choice Ex: placing healthier foods at eye level is a nudge aimed at encouraging healthier eating without directly altering food choices. The unexpected outcome, where children chose fruits and vegetables over desserts, illustrates how nudges can have unintended but positive effects. Loss aversion: Loss aversion is a cognitive biase where people tend to prefer avoiding losses over acquiring equivalent gains Ex: offering someone the choice between a guaranteed $50 or a chance to take an envelope (which may or may not contain money) highlights how individuals may be reluctant to take risks to avoid potential losses, even if the expected value is the same. How to use Loss aversion to boost sales: Limited-Time offers: Create a sense of urgency by offering limited-time promotions. Highlight the potential loss of missing out on a great deal rather than just emphasizing the gain. For example, "Act now and save 20%offer ends today!"  Free trials: Offer free trials with limited features or access. Once users experience the benefits, they may be more inclined to pay to an upgraded version to avoid losing the enhanced functionality USE A countdown compte à reboun FIRMS A firm is seen as a program of profit maximization Profit = Revenues – Costs Their revenues depend on consumers’ preferences (inverse demand function) and on the type of competition. Their costs depend on firm’s technology. In this course, we’ll consider that every firm, as a black box, want to maximise its profit. We’ll examine costs and discuss profit maximization. But within a company, actors don’t generally have the same objective. Indeed, these actors don’t assume the same risks. The management (who is risk neutral) is therefore mainly focus on the revenues of the company when the shareholders are mainly focus on profit. We’ll also focus on the determinants of firms’ boundaries: Make or buy? limites prontières COSTS Economic costs refer to opportunity costs. Indeed, reported cost data such as historic costs or factor costs aren’t especially relevant in an economic analysis. The cost function: C(q) gives us the minimal cost to produce output q given the input prices and the production technology (cfr micro). C’ (q) is the marginal cost: it’s the effect on the total cost if we produce one more unit of output. We’ll generally assume it as a constant. A company may enjoy: Economies of scale: when its average cost is decreasing by output unit. Economies of scope: when its average cost of a particular product decreases when its product range increased (when it decides to produce more different products). On the other hand, a firm can assume Diseconomies of scale: when its average cost is increasing by output unit (it often occurs when the maximum capacity of production is reached by the company and so when it must invest in a new production unit). We sort costs in fixed costs and variable costs: Fixed costs are independent of the current output level. They affect the profit but not decisions such as pricing. Particular costs are “sunk costs”. These ones are a part of the initial fixed costs (when a company decide to enter a new market) that can’t be recovered (even after reversing the decision). Example: a legal licence to enter a specific market. These costs are often exogenous to the firm and may be determined by decisions of firms already active in the market. They are therefore important to explain the formation of imperfectly competitive markets (entry barriers). The opportunity cost is the cost we paid for something, but it isn’t only the money. For example, for the university, we have to pay the minerval, the books, … but we also loose 1 year of salary (-> it’s the opportunity cost). Abstract view: We can view a firm like a “black-box”. They transform inputs and they sell their products on final markets. We summarize the firm by its profit function (π(q)) = Revenues - costs, and the revenues are determined by the demand function. THE PROFIT-MAXIMIZATION HYPOTHESIS 𝜋(𝑞) = 𝑞𝑃(𝑞) − 𝐶(𝑞) Where 𝑃(𝑞) is the inverse demand of the firm, 𝑞𝑃(𝑞) the revenues and 𝐶(𝑞) the economic costs of the firm. We focus on firm’s own quantity and ignores other variables (e.g., advertising, R&D efforts). In a market context, the profit is also affected by other firms’ choices. It’s the natural objective of owners of the firm. Yet, most large companies are not owner-managed... We have Owners VS Manager. The managers may have different objectives than profit maximization. They know better how the market works; they have the ability to control what the agent is doing for the principal. ➔ The owner would like the manager to fully maximize profits and the manager is fully responsible or the manager has a fixed salary and no responsibility (risk neutral). There should be incentives. How to align objectives? (® See ‘principal/agent model’ in book). Profit-maximizing behaviour is always the best approximation to observed market behaviour, but it provides arguably the natural benchmark for the analysis of firm behaviour. Since we are mostly concerned with firms with market power (and thus large firms), we are confident that profit maximization is often a good behavioural assumption. In particular, if we are interested in competition policy, profit- maximizing behaviour is the undisputed reference point that is used by antitrust authorities. Profit maximization can be seen as the natural objective of the owners of a firm. However, owners may have an objective function that not only contains profits but other objectives (or additional constraints). An example would be the owner of a media company who is not only interested in financial success but also has a particular world (or policy) view that he or she likes to promote. Another example is that the owner is also interested in market share or total revenue for personal reasons (this may be the implied objective function of a profit-maximizing firm that takes dynamic effects into account). One more example is that the owner has non-economic objectives such as to provide employment in his or her local community or takes particular interest in the well-being of some or all of his or her customers. This is called 'social entrepreneurship'. While there certainly exist some good real-world examples that document deviation from the profitmaximization objective of owners, we still see profit maximization as the natural starting point of any analysis of industry and therefore maintain the profit-maximization hypothesis throughout most the course. The only exception will be in Week 13, where we will explicitly study firms that include other considerations than profit in their objective function. Taking into account that most large companies are not owner-managed, we must address an additional important question: Is profit-maximization a reasonable objective function of firms even if owners have this objective? In firms which are not owner-run, top management may have different objectives from the owners of a firm. Top management may have non-monetary incentives such as empire building. A good example is merger decisions, which may partly be explained by monetary and non-monetary incentives of top management to increase the scope of the firm, but which may not be in the interest of owners. Another reason is that many decisions are not taken by the top management but by middle management. Here, the incentives of the middle manager may be different from those of top management. The middle manager may not act in the interest of the whole firm but delegation may still be desirable for a number of reasons, in particular because of asymmetric information problems within the firm and limited managerial span of the top management. Another reason for the effect of firm organization on firm decisions is dispersed information within a company together with strategic communication. Through performance-based pay, the owner can attempt to better align his and the manager’s incentives. The principal-agent problem: in most modern firm, the company are hold by shareholders (principal). These principal hires agent to manage the company. Those managers have most of the time different objectives than the shareholder. Typically, shareholder want money (maximization of money) and manager want different things. They have to align their interests. MARKET INTERACTION PERFECT COMPETITIVE PARADIGM In perfectly competitive market Firms take the market price as given Market price result from combined action of all firms and all consumers Firms face a horizontal demand curve Marginal revenue = price Profit maximization o Marginal revenue = marginal cost If firms face a horizontal demand curve and profit maximization, then Price = marginal cost MONOPOLY A monopoly is a firm who is the only one to serve the market demand, which aggregates all the individual demands expressed by the consumers who are present on the market. The monopoly can choose indifferently, a price or quantity. Like any profit-maximizing firm, the monopoly sets its optimal quantity such that marginal cost is equal to marginal revenue. Marginal revenue tells us by how much total revenue changes when one additional unit of the product is sold. > un revenu sup géneré par la vente d'une unité additionnel d'un produit - → For any unit, the marginal revenue for a monopoly is inferior to the price at which this unit is sold. Because consumer accept to buy more of the product only if the price decreases. So, selling one more unit has two opposite impacts on the monopoly’s total revenue: one more unit is sold but, to sell it, the monopoly has to accept to lower price, not only on this extra unit but also on all units that were already demanded. Example: if we have two people. One is willing to pay 100 for product p but the other person is willing to pay 80. So, we can sell 2 products at 80 but only one product at 100. We then have a marginal revenue: MR = 80 – (100-80) = 60. MC: Marginal cost curve (constant at a level c) DA: Demand curve MRA: Marginal revenue (intersection with MC) MONOPOLY PRICING FORMULA Downward-sloping inverse demand curve: 𝑷(𝒒) with q the quantity and P(q) the maximum price that consumers are willing to pay for this quantity. Price depends negatively on the quantity the firm offers on the market so it’s a negatively sloped fraction. Increasing cost function: 𝐶(𝑞). Marginal cost is C’(𝑞); may be constant or upward-sloping We want to solve de monopoly problem: choose the quantity that maximizes profit FOC: The inverse price elasticity of demand, noted is given by: We can rewrite the FOC: Where is the markup (or Lerner index). The markup, , measures by which percentage of the price the firm is able to increase price over marginal cost. It’s a measure of market power. Any markup > 0 means that we aren’t in a perfectly competitive market (perfectly competitive market: markup = 0 because price is equal to marginal cost). According to the monopoly pricing formula, the markup is inversely related to the elasticity of demand 𝜂. ➔ A profit-maximizing monopolist increases its markup as demand becomes less price elastic. Markups are higher in markets whose demand curves are less elastic. IMPERFECT COMPETITION A firm can make its decision in isolation, either because it feels that its decision has no impact on the market (the perfectly competitive paradigm) or because it is the single, or dominant, firm in the market. Outside these extreme settings, a restricted number of firms are active in the market and none of those firms can ignore that market outcomes depend on the combination of the decisions taken by all of them. As a result, firms would not be rational if they made their decisions in isolation. Instead, they must factor into their maximization programme the fact that the other firms are also maximizing their own profits and that the profit levels are interdependent. As we explained above, game theory offers tools to solve such multipersonal decision problems. In particular, the concept of Nash equilibrium provides us with predictions as to what the market outcome will be. Why is it that only a few firms are active on the market? If we look at the current landscape of important industries, we observe that firms such as Microsoft, Boeing and Porsche clearly do have market power. For those firms, a small increase in price does not lead to a loss of all or most of the market share. Even small local retailers may enjoy market power in the sense that small price changes do not lead to drastic changes in demand. The reason is that although there are, for example, many bakeries and butchers, they are located at different places and cater to different tastes. Here, product differentiation gives rise to market power. Alternatively, firms may offer identical products or services but consumers may not be perfectly informed. Then firms enjoy market power due to consumers being less than perfectly informed (or incurring search costs to obtain this information). Finally, consumers may be locked into long-term contracts or may have become accustomed to a particular product. Then a firm has some market power over these captive consumers due to consumer switching costs. Market power and its sources are at the core of this course. Because of market power, firms may want to invest in exploring their market environment and finding suitable instruments to improve their profits. Antitrust authorities may limit the set of actions available to firms by punishing certain types of behaviour or by interfering ex ante. For instance, mergers are only cleared if the antitrust authority does not foresee anticompetitive behaviour as the result of the merger. While market power appears at first sight to be a static concept, this view is misleading. Firms enjoy market power because other firms do not find it worthwhile to offer identical or similar products or services. In particular, fixed costs define a minimum level of output a firm has to achieve in the industry to make non-negative profits. However, the presence of other market characteristics alone may make it unattractive for firms to enter the industry. More generally, in some markets, only one or a small number of firms is viable. The next video explains why Boeing and Airbus are currently dominating the market for aircrafts. STRATEGIC INTERACTION A monopolist is by definition the only firm to be active in the market; moreover, if the environment is such that no entry is possible and if there is a large number of buyers, whose individual decisions have a negligible impact, the monopolist can make its one-shot decisions in complete isolation. Things change as soon as other firms are present in the market, or could be present (i.e., if there is a threat of entry). Then, what these other firms do, or could do, affects the first firm’s profits and it is thus wise for this firm to take this interaction into account in its decision process. That is, if other firms are present on the market, it is important to anticipate their actions; or, if other firms may enter the market, it is possible to take advance actions so as to discourage entry or to limit its negative effects. Similarly, if the firm remains the only seller but faces a single buyer, the bargaining power of this buyer has to be factored into the decision process. The analysis of such situations (i.e., oligopoly problems, monopolies threatened by entry or bilateral monopolies where a single seller faces a single buyer) belongs to the realm of game theory (game theory is concerned with situations where the players--the decision-makers-- strategically interact). NASH EQUILIBRIUM The Nash equilibrium is the prediction of market outcome when firms interact strategically. RUNNING STORY  Different scenarios regarding: o What “glints” exactly are o Other competitors in the market o Presence of intermediaries o What market participants know o Role of regulation