Introduction to Industrial Organization
Lecture 2
Introduction
1. Four market structures
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
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
Oligopolies - few sellers in a market
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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
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Demand for a firm's product is d, because d is a fraction of the market
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
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
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
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
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