1. What is IO about: An Example1
Glaxo-Wellcome is a leading pharmaceutical company. Its best-seller product in mid1980s-90s was Zantac, an ulcer and heartburn medicine. ($1.6 billion in 1990)
It costs relatively little to produce Zantac, but Glaxo-Wellcome sell it at a very high price.
Question: Why Glaxo-Wellcome can charge a price without losing a significant number of customers?

2. What is IO about: An Example
One answer: legal protection. Glaxo Wellcome holds a number of patents that protect its best-seller drug ZANTAC.
But the legal protection enjoyed by Glaxo Wellcome is ending. 1996: Novopharm produces a generic Zantac + later other companies. And there were several close substitutes in the same market: Tagamet produced by SmithKline.
Doctor: Branded Zantac and generic Zantac have the same effect.

3. What is IO about: An Example
The price of Zantac is much higher than generic Zantac. 30 tablet box of Zantac, $90; 250 tablet box of generic Zantac, $95.
Question: without much legal protection, how can Zantac be sold at a such high price?
Answer: Glaxo-Wellcome spend hundreds of millions of dollars in advertising. Zantac enjoys brand loyalty from consumers and doctors.

4. What is IO about: An Example
Key: The inner quality of the product doesn’t matter so much; what matters is consumers’ perception of the product. Advertising can influence consumers’ perception, thus establishing brand loyalty.
How Zantac came into being?
Back to late 70s, Glaxo and Wellcome are two independent companies. And the dominant firm in the market is SmithKline, with Tagamet as the most popular drug in the field.

5. What is IO about: An Example
Glaxo is strong in respiratory and gastrointestinal medications while Wellcome is strong in antiviral remedies. Their strengths are complementary.
Glaxo and Wellcome merged to form Glaxo Wellcome. The merger creates synergies. And Zantac is one of its fruits. Combining with effective advertising, Zantac become the most popular drug among ulcer and heartburn medicine.

6. Summary of The Example
Glaxo Wellcome enjoys a significant degree of market power.
Glaxo Wellcome gained market power through a clever merger and an aggressive marketing strategy.
For a time, Zantac’s position was protected by patent rights. This is no longer the case; now differentiating the product from generic products becomes the priority.

7. Central Questions in IO (I)
Is there Market Power?
Definition: Market power is the ability to set prices above marginal cost.
For some markets, yes. For some markets, no.

8. Is There Market Power? Example 1 Example 2
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.
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.

9. 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.

10. 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 example of the next slide)

11. How do firms acquire market power (an example)
British Sky Broadcasting Group (BSkyB) and Ondigital are competitors for the British digital TV market. In 1999, BSkyB introduced an aggressive package that includes: a free set-top decoder box, free internet access and a 40% discount on telephone charges.
Intention
preempt its rivals by creating an early lead in installed base of subscribers.
Result
BSkyB’s shares were up by 12%, whereas Ondigital’s slid by 1.8%

12. How do firms maintain market power
Market conditions are changing: patents expire; imitation takes place; protected industries are deregulated…
Incumbents usually use marketing strategies to maintain market power.

13. How do firms maintain market power( an example)
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.
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.

14. Question (III): What are the implications of market power?
Distributional effect
Firms’ profits increases.
Consumer’s 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.

15. 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.

16. An opposite view Austrian School (Schumpeter)
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.

17. 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.

18. 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)

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

20. Two approaches to IO Structure-conduct-performance (SCP) paradigm.
Dominated research before late 1970s.
Game theory.
driven the theoretical research in IO since late 1970s.
Strategic interactions capture the essence of imperfect competition.

21. SCP Paradigm
Market structure (number of sellers, degree of product differentiation…) determines the conduct of firms (pricing, advertising,…)
Firms’ conducts determines industry and firm performance (profits, efficiency).