1. Industrial organization (or Industrial Economics) is concerned with the workings of markets, in particular, the way firms interact and compete with each other. Industry ≠ manufacturing Also subject matter of microeconomics  IO is a chapter of Micro. [there is no subject as IO] Difference : IO emphasizes firm strategies that are characteristic of market interaction: price competition, product positioning (differentiation), advertising, R&D, etc. Micro : Monopoly or Perfect competition IO : oligopoly – competition among a few firms IO : economics of imperfect competition

2. 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?

3. What is market power?
Market power is the ability to set prices above cost, especially above incremental or marginal cost. What is marginal cost? Marginal cost is defined as the cost of producing one extra unit.

4. Market power is measured by
the Lerner index : L = (P − MC)/P . MC = marginal cost, P = price of output. L varies between 0 and 1, 0 indicates no market power, 1 indicates maximum market power. One obvious problem is that the marginal cost is difficult to observe. But if unit costs are approximately constant you can use the profit rate as a proxy for Lerner index. (P − c)/P = (Pq − cq)/Pq = Profit of the firm/Revenue of the firm

5. An Example
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 sells it at a very high price.

8. Question: How can Glaxo-Wellcome charge a price without losing a significant number of customers?

9. Example continued
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.
Doctors: Branded Zantac and generic Zantac have the same effect.

10. Example continued
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.

11. 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.

12. A little bit of history : 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.
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 for ulcer and heartburn.

13. 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.

14. 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.