1. The 4 central questions in IO
(1) Is there market power?
(2) How do firms acquire and maintain market power?
(3) What are the implications of market power?
(4) Is there a role for public policy regarding market power?

2. Is There Market Power?
Example 1 Among 43 large airports in US., 10 of them are controlled by one or a few airlines. At these airports, on average fliers were paying 31% more than at the remaining airports.

3. Example 2
The prices of office supplies. In areas where only one chain (say, Staples or Office Depot) operates, prices can be up to 15% higher than in other areas.

4. Is there market power?
Arnold Harberger,1954, article published in AER “Monopoly and resource allocation”
He invented the Dead Weight Loss triangles. He uses industry level data from 1920s that covers about a ten year period. He finds that the monopoly power in US manufacturing industries is small.
A less obvious problem is that
The data on accounting profits reported by business firms do not correspond to the economic concept of profit.

5. Another study on market power
Robert Hall article published in JPE
“The relationship between price and marginal cost in the US industry”
He uses more recent and firm level data.
He obtains the marginal cost for a firm by dividing the increase in cost from year t to year t+1 by the increase in output in the same period.
MAIN FINDING : Prices may be three times as high as the marginal cost.

6. Is There Market Power? Chicago School opinion:
As long as there is free entry into each industry, the extent of market power is never significant.
If a firm were to persistently set prices above cost, a new firm would find it profitable to enter the market and undercut the incumbent.

7. Central Questions in IO (II)
How do firms acquire market power?
Patent. In 1960s, Xerox invented plain-paper photocopying and patented it.
Marketing strategy. (see the ZANTAC example)

8. How do firms maintain market power
American Airlines (AA) is the Dominant airline at Dallas/Forth Worth hub. When one of the competitors, Vanguard entered the market, AA decreased its air fares.
The fare between Dallas and Kansas City, fell from $108 to $80.
After Vanguard exited, AA gradually raised the fare to up to $147 in 1996.

9. The excessively low fares charged by AA was intended to drove its competitors out of the market and enjoy higher profits later.
Moreover, AA developed a reputation of toughness, which discourages future potential entrant to enter.

10. Another example:
1998 Japan deregulated its airline industry. Skyline Airlines and Air Do entered the market that was dominated for 35 years by Japan Airlines (JAL) and All Nippon Airlines (ANA). Incumbents : respond by aggressive price cuts JAL and ANA carry out maintenance services for all airline companies. (There are no independent servicing companies in Japan.)

11. Question (III): What are the implications of market power?
Distributional effect
Firms’ profits increases.
Consumers’ surplus decreases
Allocative inefficiency
Overall, firm’s increase in profit is less than the loss of consumer’s surplus. Deadweight loss is the result.
The quantity sold will be less than the efficient one. □

12. The price of monopoly is upon every occasion the highest which can be got. The natural price, or the price of free competition, on the contrary, is the lowest which can be taken … The one is upon every occasion the highest which can be squeezed out of the buyers, or which, it is supposed, they will consent to give: The other is the lowest which the sellers can commonly afford to take, and at the same time continue their business.”
“… it always is and must be the interest of the great body of the people to buy whatever they want of those who sell it cheapest. The proposition is so very manifest, that it seems ridiculous to take any pains to prove it; nor could it ever have been 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) ◄

13. More implications of market power
Productive inefficiency
Competition encourages firms to reduce costs. Less competition (more market power) reduces firms’ incentive to innovate.
European airlines (regulated) are less efficient than American airlines (deregulated).
Rent seeking
If market power is created by government intervention (regulation), then firms may spend unproductive resources to influence policymakers and gain market power.

14. “The best of all monopoly profits is the quiet life.” Sir John Hicks

15. Question (III): What are the implications of market power?
Productive inefficiency
Competition encourages firms to reduce costs. Less competition (more market power) reduces firms’ incentive to minimize costs.

16. (1996, Journal of Political Economy)
Stephen Nickell’s research on a sample of more than 600 UK firms shows that when controlling for the quantity of inputs, firm’s output is increasinag in the number of competitors, and decreasing in market share and industry concentration.
 (1996, Journal of Political Economy) ◄

17. The Austrian School (Joseph Schumpeter)
An opposite view
The Austrian School (Joseph Schumpeter)
“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.”
From “Capitalism Socialism and Democracy”

18. Joseph Alois Schumpeter, (February 8, 1883 – January 8, 1950) was an economist from Austria and an influential political scientist.
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.

19. The Schumpeterian View :
Large companies (resulting in market power) is a good thing; only they have the ability to mobilize substantial amount of resources to invent new technology. Market power is a precondition for technological progress.

20. Question (IV): Is there a role for public policy?
Regulation
It applies to firms which detains monopoly or near-monopoly power.
Example: Until 1996, AT&T needed the approval of regulating agency each time it changed its long-distance telephone fares.

21. Antitrust policy
Prevent firms from taking actions that increase market power in a detrimental way.
List of suspicious actions
collusion
predatory pricing
bundling (Microsoft Vs Netscape case)

22. On March 3, 1998, Bill Gates and Scott McNealy each testified before the U.S. Senate committee on the judiciary as part of a hearing on competition in the computer industry. Here are selected excerpts from their testimony:
Bill Gates, Chairman and CEO, Microsoft
“I am compelled to say a word about Microsoft’s size and place in the computer software industry … Microsoft is often referred to as a “software giant,” The facts, however, tell a different story. While Microsoft is clearly a leader in the computer software industry, our revenues account for less than 5% of total worldwide software revenues of $253 billion and only 1% of the information technology industry’s collective revenues of $1 trillion … As suggested by Microsoft’s relatively small revenue share, the computer software industry is highly fragmented …”

23. Scott McNealy, Chairman and CEO, Sun Microsystems
“… Today, 85% of the world’s existing PCs contain operating systems from Microsoft and over 95% of all PCs currently being shipped contain a Microsoft operating system. Currently, there is virtually no competition in the PC operating system market, and PCs with Microsoft operating systems are now the gateway device by which the overwhelming majority of consumers access the Internet”

24. Chicago School View
Market power doesn’t exist without government intervention.
It is government regulation that creates market power. (rent-seeking and corruption).

25. Now we come to Silicon Valley and Microsoft
Now we come to Silicon Valley and Microsoft. I am not going to argue about the technical aspects of whether Microsoft is guilty or not under the antitrust laws. My own views about the antitrust laws have changed greatly over time. When I started in this business, as a believer in competition, I was a great supporter of antitrust laws; I thought enforcing them was one of the few desirable things that the government could do to promote more competition. But as I watched what actually happened, I saw that, instead of promoting competition, antitrust laws tended to do exactly the opposite, because they tended, like so many government activities, to be taken over by the people they were supposed to regulate and control. And so over time I have gradually come to the conclusion that antitrust laws do far more harm than good and that we would be better off if we didn’t have them at all, if we could get rid of them. But we do have them.
Milton Friedman
from “The Business Community's Suicidal Impulse” in Cato Policy Report, March/April 1999 Vol. 21, No. 2