ECON 330 Lecture 4 Wednesday, September 25

Webpage : https://ais.ku.edu.tr/course/22582/Default.html Lecture notes for Monday are posted Class records are also posted (for last three class meetings) “1” means you handed in your written answer, no entry means you didn’t Newcomers: pick up your syllabus We have still 86 students enrolled in econ330 See me after class if you are still urgently desperately trying to add Econ330 to your Fall ’13 schedule

Now, the lecture

Please turn off laptops tablets phones etc!

So far we talked about… What is market power? How is it measured? Examples of firms with MP How do firms acquire MP? Patents etc How do firms maintain MP? Advertising predatory pricing etc

But… Why do we care about market power? What if the firms in industry XYZ have substantial market power? What are the consequences? What happens when firms market power?

The implications of market power Today’s lecture The implications of market power

The implications of market power 1. Distributional effect Profits increase. Consumers’ welfare decrease (Consumer’s welfare is measured by consumers’ surplus)

Consumers’ surplus is… … the difference between the amount of money the consumer is willing to pay and the amount actually paid. 40,000

Distributional effect of market power price, P 10 8 60 transfer of welfare from consumers to firms = Δp x Q = 2 x 50 = 100 Demand, D(P) 50 quantity, Q

The distributional effect in Adam Smith’s own words The price of monopoly is (always) the highest which can be squeezed out of the buyers (…) The price of free competition, (…), is the lowest which the sellers can commonly afford to take, and at the same time continue their business. Smith calls the competitive price “the natural price.”

Implications of market power: 2. Allocative inefficiency The increase in profit is less than the loss in consumer’s surplus. This means that market power creates a a net loss in total welfare. This welfare loss is called the Deadweight Loss (DWL) of market power. The quantity sold is less than the efficient (competitive) output level.

DWL: the graph

The DWL (allocative inefficiency) in Adam Smith’s own words “… it always is (…) the interest of the great body of the people to buy whatever they want of those who sell it cheapest. The proposition is so OBVIOUS, that it seems ridiculous to take any pains to prove it; It would never be called in question, had not the interested sophistry of merchants and manufacturers confounded the common sense of mankind. Their interest is, in this respect, directly opposite to that of the great body of the people. Adam Smith, The Wealth of Nations (1776)

Implications of market power “The best of all monopoly profits is the quiet life.” Sir John Hicks Sir John Hicks received the Nobel Prize in Economic Sciences in 1972 for his contribution to general equilibrium and welfare theory.

Implications of market power: 3. Productive inefficiency Competition encourages firms to reduce costs (to be more cost efficient). Less competition (more market power) reduces firms’ incentive to be efficient in terms of production costs. Example: European airlines (regulated) are less efficient than American airlines (deregulated)

Evidence for productive inefficiency Stephen Nickell, "Competition and Corporate Performance," Journal of Political Economy, vol. 104(4), pages 724-46, 1996 Stephen Nickell’s research on a sample of more than 600 UK firms shows that with a given level of inputs, firms Produce more output if they have more competitors, Produce less output if they have a bigger market share Produce less output if they are in a more concentrated industry.

Implications of market power 4. Rent seeking If market power is created by government intervention (regulation), then firms may spend unproductive resources to influence policymakers and gain/maintain market power. Richard Posner, University of Chicago Rent seeking: spending resources to increase one's share of existing wealth, instead of trying to create wealth. Rent-seeking reduces social welfare because resource are used for unproductive activities.

So, is no one going to say something positive about big firms with market power?

Yes. This guy The prophet of innovation, The father of creative destruction

Implications of market power: An opposite view “As soon as we go into the details and inquire into the individual items in which progress was most conspicuous, the trail leads not to the doors of those firms that work under conditions of comparatively free competition but precisely to the doors of the large concerns.” Joseph Schumpeter, from “Capitalism Socialism and Democracy”  

The Schumpeterian View, (in plain English) (only?, mostly?) Large companies (that have market power) can mobilize substantial amount of resources to invent new technologies. Schumpeter: “Market power is a precondition for technological progress.”

Schumpeter’s “creative destruction” [I]n capitalist reality as distinguished from its textbook picture, it is not [textbook] . . .competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization (…)–competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives (1950: 82).

Joseph Schumpeter, (1883 –1950)   In his younger days he had three wishes: to be a great economist, a great horseman, and a great lover. He later said that two of these three wishes had been granted to him.

Is there a role for public policy? There are two major types of government (public policy) responses to market power: Regulation Competition (anti trust) policy

Regulation (düzenleme ve denetleme) It applies to firms that already have monopoly or near- monopoly power. A regulated company needs the approval of regulating government agency each time it changes prices. utility companies: electricity, water, gas distribution, telecommunications, transportation (railroads) companies etc and financial institutions Turkish Case: Enerji Piyasası Düzenleme Kurumu, BBDK, Bilgi Teknolojileri ve İletişim Kurumu

Antitrust (or competition) policy Goal: prevent firms from taking actions that increase market power to cause harm to consumers. Suspicious actions collusion and price fixing predatory pricing mergers for monopolization

The oldest and the most well-known model of analyzing industries

The SCP

S-C-P The Structure-Conduct-Performance (SCP) approach. Joe Bain. developed by Joe Bain in late 40s and 50s. Summarized in his famous book “Barriers to New Competition”. (1956) Joe Bain. Harvard PhD in economics in 1940 under Joseph Schumpeter. long productive successful research career, honored as “Distinguished Fellow” by the American Economic Association in 1982, “the undisputed father of modern Industrial Organization Economics.” SCP has been very influential and widely used in analyzing markets and industries.

SCP: The terms explained (S) Market Structure number of sellers (industry concentration), degree of product differentiation, barriers to entry (to be explained on next slide) (C) Firms’ conduct (behavior) pricing: competition vs. collusion (to be explained on next slide) also R&D advertising? (P) Performance efficiency, technological progress and innovation

What is an “entry barrier” Bain’s definition: An entry barrier is the set of technology or product conditions that allow incumbent firms to earn economic profits in the long run.

Bain’s definition of “entry barrier” Bain identified three (+1) sets of conditions: economies of scale, low units costs achieved only at very high production levels large (financial) capital requirements product differentiation brand names, customer loyalty etc absolute cost advantages of established firms

What is collusion? Collusion is cooperation between firms in an industry that reduces market competition, with the result of higher profits and lower consumer welfare.   Examples include price fixing controlling or limiting production levels, market sharing

Back to SCP Bain’s analysis is based on a view of the world in which “entry barriers” determine the number of firms which, in turn, determines the competitiveness of the industry, and thereby determines each firm’s profit, and rate of return.

The SCP view of the world CAUSALITY: S  C  P Market structure determines conduct With few firms, firms can collude more easily, and raise prices. Conduct determines industry and firm performance. With collusion prices and profits will be higher, efficiency, and consumer welfare will be lower.

Bain’s results from 1950s: Relationship between Structure and Performance Bain compares industries with CR8 > 70% to those with CR8 < 70%. He finds that … The average rate of return for industries with CR8 > 70% is 11.8% compared to 7.5% for industries with CR8 < 70%.

But what is CR8?

Measuring industry concentration Two commonly used measures are:   1. Concentration Ratio: CRn The market share of the top n firms Commonly reported as CR4 and CR8 CR4 = 0.71 means that … the biggest 4 firms in the industry have a 71% market share.

2. Herfindahl-Hirschman Index (HHI) – For an industry with N firms, HHI = where si is the market share of the ith firm. – The HHI captures both the average firm size and the inequality of size between firms

EXAMPLE: number of firms ≠ concentration Industry A 10 firms, each firm has 10% market share Industry B 11 firms, one firms has 90% market share, each of the remaining firms has 1%. Both industries have (almost an) equal number of firms, but the “concentration” (size distribution) is very different across the two industries.

Industry XYZ Firm Market share (%) A 50 B 20 C D 10 If it is not too much to ask, can you please write your answer on a piece of paper? Thank you! Industry XYZ Firm Market share (%) A 50 B 20 C D 10 Compute the HH Index for industry XYZ. Create another industry that has more firms than industry XYZ but is more concentrated (as measured by the HH Index.)

So, what threshold value of HHI makes the market concentrated?

The USA case Based on their experience, the Agencies (U.S. Department of Justice and the Federal Trade Commission) generally classify markets into three types: Unconcentrated Markets: HHI below 1500 Moderately Concentrated Markets: HHI between 1500 and 2500 Highly Concentrated Markets: HHI above 2500

End of the lecture