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Introduction to Industrial Organization
Lecture 2



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

A Competitive Market

  1. 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

  2. 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 product from a oligopoly

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

  1. 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

Market with a Monopoly

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

Monopoly reduces production to increase market price

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


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