1 Chapter 1. Introduction to Industrial Organization 1.What is industrial organization? 2.What are the different approaches studying industrial organization? 3.Antitrust policies 4.Examples in the real world

2 Industrial Organization: What, How, and Why? WHAT is Industrial Organization (IO)? Study of how firms behave in markets focusing on imperfect competition Whole range of business issues: –price of a dozen roses –payment to be official sponsor of major events –which new products to introduce –merger decisions –methods for attacking or defending markets IO takes a strategic view of how firms interact

3 HOW IO proceeds in practice? Rely on the tools of game theory –focuses on strategy and interaction Construct models: abstractions –well established tradition in all science –simplification but gain the power of generalization Empirical Analysis—Use theory to form testable hypotheses –Measure scale economies –for entry deterring actions –Experiment with penalty for price-fixing –Examine the impact of advertising

4 WHY do Industrial Organization? Long-standing concern with market power –Sherman Antitrust Act (1890) due to market power of firms such as Standard Oil/American Tabacco…….. –Need for anti-trust policy recognized by Adam Smith The Wealth of Nations (1776), “The monopolists, by keeping the market constantly understocked, by never fully supplying the effectual demand, sell their commodities much above the natural price.” “People of the same trade seldom meet together, even for merriment or diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

5 Sherman Act (1890) –Section 1: prohibits contracts, combinations and conspiracies “in restraint of trade” –Section 2: makes illegal any attempt to monopolize a market Clayton Act (1914) –intended to prevent monopoly “in its incipiency” –makes illegal practices that “may substantially lessen competition or tend to create a monopoly” Federal Trade Commission (1914) endowed with powers of investigation/adjudication to handle Clayton Act violations However, application affected by rule of reason –proof of intent/the law does not make mere size an offence –The U.S. Steel case of 2002: the firm had grown to control over 70% of market via merger, but the court found no violation of antitrust

6 The Structure-Conduct-Performance Model: establish link between market structures and the conduct of firms in the market => performance of market in terms of economic efficiency/social welfare –Spectrum of markets between pure competition and pure monopoly –Closer to monopoly means worse welfare loss –IO mission is to identify link from market structure to firm conduct (pricing, advertising, etc) to market outcomes (deadweight loss) Structure, Conduct, and Performance

7 Market structure is identified with the degree of concentration (HHI) or the percentage of output produced by the largest firms in an industry (CR4) Researchers try to measure the link between the industrial performance, profitability, and the industry structural features, concentration Positive correlation found between profitability and concentration => the higher concentration the higher industry profits Positive correlation found between profitability and advertising => the higher advertising the higher industry profits by increasing brand royalty and increasing entry barrier

8 Limitations of SCP Models Regardless of market power/concentration, the most efficient/low cost firms can gain the largest shares of the market due to the firm’s superior of technology and management Difficult to define relevant market/distinguish short-and long-run profit The firm conduct does not pay attention to firm’s strategic interactions Industry structure can not be completely defined by concentration; Even a highly concentrated industry might be forced to price competitively if there were new firms ready and able to enter and compete away the profit of any firm pricing above the competitive level.

9 The Chicago School point outs: –Good as well as bad reasons for monopoly including superior skill and technology –Potential entry can discipline even a monopoly –Structure is endogenous/causality difficult to determine Post-Chicago –Game theoretic Emphasis –Competitive based on SCP discipline can fail –Careful econometric testing to determine correct policy in actual cases for FTC: ADM (collusion) Toys R Us (exclusive dealing) American Airlines (predatory pricing) Merger wave (Maytag and Whirlpool) Chicago and Post-Chicago Frameworks

10 The New Industrial Organization The “New Industrial Organization” is a blend of features –theory in advance of policy –recognition of connection between market structure and firms’ behavior Contrast pricing behavior of: –grain farmers at cash market vs. futures market –gas stations: Texaco, Mobil, Exxon –computer manufacturers (based on product life cycle and competitors) –pharmaceuticals (proprietary vs. generics)

11 Contemporary Industrial Organization WHAT: The study of imperfect competition and strategic interaction HOW: –Build on game theory foundation –Derive empirically testable propositions –Econometric estimates of relations predicted by theory WHY: –Motivated largely by antitrust concerns –Also interest in private solutions to inefficient market outcomes