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Samenvatting Industrial Organization
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Lecture notes of 11 pages for the course Industrial Organization at UVT
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Chapter 1: Introduction- Two approaches to studying IO:
*Structure-Conduct-Performance (SCP): there is a direct relationship between market structure,
market conduct and market performance. Basic market conditions determine market structure,
structure determines conduct and conduct determines performance.
*Chicago school: relies heavily on price theory models to make predictions about expected conduct
and performance and to design empirical tests of their theories.
Consensus: New Industrial Organization (game theory)
- Static models deal with a moment in time; decisions made simultaneously (relatively simple, very
stylized). Static efficiency requires P=MC in short run & P=LRAC in the long run.
- Dynamic models deal with changes over time (more realistic, more complex). Dynamic efficiency
requires an optimal rate of technological process (innovation). P>MC and LRAC.
- Case studies provide detailed examinations of specific industries. Statistical studies suggest for
example that the relationship is different depending on the types of goods being considered.
Chapter 2: The firm and its costs.
- The traditional neoclassical firm is represented by a production function that summarizes the
relationship between input and output given the current technology. Each firm is assumed to
maximize profits, making it possible to precisely predict its output and pricing decisions.
- The firm can be regarded as a series of contracts (implicit/explicit) between a number of parties,
including the workers, the managers, and the suppliers of capital.
Firms consist of many people with different goals, capabilities, and constraints. These individuals are
connected by contracts (explicit=write down or implicit=expectations/promises), which clarify who
has which rights/obligations and who has residual control rights and residual income rights. Residual
control: power over decisions not explicitly assigned.
- Coase argued that a firm would expand until the costs of undertaking a transaction internally were
just equal to the costs of using the market to handle that transaction. The costs of using the market
to conduct business are called transaction costs. Williamson has built upon this, writing extensively
on the importance of transaction costs and the types of organizational structures that have been
developed to minimize transaction costs.
-Three cost advantages of using the market (Williamson) Economies of scale, economies of scope
and reduction of risk.
- Two assumptions in transaction cost economics
*Bounded rationality: recognizes that limits on knowledge, foresight, skill and time constrain
individuals ability to solve complex problems.
*An incomplete contract that doesn’t cover all possible outcomes could be used to carry out
transactions if it were not for the second assumption: opportunism (to act in self-interest).
- Possibility of opportunistic behavior increases in asset specificity: if a tangible or intangible asset is
specific to a transaction, its value in alternative transactions is significantly lower (≠ general).
- Williamson optimal firm size when marginal governance costs = marginal transaction costs.
- The Resourced based Theory of the Firm: property based resources have legally defined property
rights, knowledge-based resources: for example technical expertise.
- Corporation: separate legal entity, owners have limited liability, shares can be easily sold, infinite
life.
- In corporations (with many owners) professional managers employed for day-to-day decisions,
overseen by board of directors (representatives of shareholders). In theory/legal rules, board of
directors actively monitor whether managers operate the firm in line with owners‘ objectives. In
practice, the candidates for the board of directors are selected by managers. Few stockholders
typically attend an annual meeting, instead the give the managers their proxies or permission to
vote.
- When ownership and control are separate, profit max. and utility max. may conflict as managers
,pursue objectives other than max. profits (max. own utility).
Unclear what managers actually maximize. Some suggestions:
*Revenue (Baumol): disregard costs profits↓
*Perks (&profits) (Williamson): fancy offices, jets, art, …
*Quiet life (Leibenstein): “X-inefficiency” putting in too little effort, not continuously striving to
find the least costly way.
Managers may also be to risk averse to protect their jobs. Rules of thumb & own experience to
produce a “satisficing“ profit (= minimum acceptable profit level) PAGE 36
- Constraints on managers:
*Incentive contracts managerial pay depends on owners profit (shares or stock options)
*Stockholder revolt owners always have the option of selling shares
*Market for corporate control if s.b. thinks a firm is badly managed, he may take it over, replace
the management, and change the strategy.
- Accounting costs are the costs reported by firms in their financial reports. The economic cost of an
input is defined as the payment that input would receive in its best alternative employment. The
opportunity cost of a good is the value of the resources used to produce that good in their best
alternative use.
- Production function: a mathematical relationship that identifies the max. quantity of a good that
can be produced per time period using a specific combination of inputs.
- AFC decrease in output, AVC first decrease in output, then increase. This leads to:
*For small q: Economies of scale (= decreasing AC), ECS
*For large q: Diseconomies of scale (=increasing AC),DECS
- The minimum of AC occurs at a higher level of output than the minimum point of AVC because AC
reflects the steadily decreasing average fixed cost in addition to AVC. FIGURE 1
- In the long run all inputs are flexible long-run costs can be optimized and are never higher than
short-run costs. LRAC is the envelope of the short-run AC-curves, which depend on fixed
capital/other input factors.
- Increasing returns to scale: if a proportionate increase in all inputs results in a more than
proportionate increase in output (LRAC decreases; output increases). Decreasing returns to scale: if a
proportionate increase in all inputs leads to a less than proportionate increase in output (LRAC
increases).
- Economies of scale exist if average cost falls as output increases cost falls only if MC < AC
Diseconomies of scale if average cost increases only when MC > AC
S= AC(q)/MC(q) S>1 economies of scale; S<1 diseconomies of scale
- Sometimes it is relatively cheaper to produce several types of products with certain inputs than only
one type: multiproduct firms economies of scope
Sc= C(q1,0) + C(0,q2) – C(q1,q2) / C(q1,q2) SC measures the (normalized) degree of cost savings by
joint production of products 1 and 2.
Chapter 3: Competition and Monopoly
- DIA 27
- Perfect competition: each firm views the market price as independent of its own level of output.
(Each perfectly competitive firm earns zero economic profits in the long run)
Long run characteristics:
1.Large number of buyers and sellers 4.No transaction costs (bargaining/opportunism)
2.Homogenous product 5.Free entry and exit.
3.Perfect information
- Every supply firm and also buyers are price takers.
- The price elasticity of demand is a measure of how sensitive quantity demanded is to a change in
price. The percentage change in quantity demanded divided by the percentage change in price. The
higher the absolute value of the elasticity of demand, the larger the change in quantity resulting from
a change in price. If |PED|>1 (<1) [=1], demand is elastic (increase in price: reduced quantity
, demanded) (inelastic) [unit price elastic]. DIA 31
- Perfect competition P=MR, if a perfectly competitive firm wants to produce any output, it will
choose the level for which price equals MC.
- Stay open when P > AVC
A profit max. firm will produce some output in the short run as long as P ≥ AVC (P=AVC shutdown
point at the minimum of AVC). Short [long]-run firm supply curve: increasing part of MC-curve,
above the AVC-minimum [ACL-minimum].
In the long run, produce output as long as P ≥ AC. The long run equilibrium price
P*=SRMC=LRMC=SRAC=LRAC
- Efficiency in the level of output, called allocative efficiency (pareto), requires that the marginal
benefit of producing another unit of output equal its MC. Achieved when no possible reallocation of
resources could make one agent better off without making at least one other agent worse off.
- Productive efficiency: Achieved if a firm (i): uses all inputs it has to produce output and (ii) uses
available inputs in the output maximizing combination.
- Consumer surplus is the difference between the max. amount consumers are willing to pay for a
good and the amount they actually pay. Below the market demand curve, above market price.
Producer surplus is the difference between the market price the producer receives for selling a unit
of output and its reservation supply price, the lowest price for which firms would be willing to
produce. Above supply curve, below market price.
- Monopoly: market price depends on monopolist‘s output decision: p = p(q). Because a monopolist
faces the downward-sloping market demand curve, the only way it can sell an additional unit of
output is by lowering the price on all units P ≠ MC
Trade-off of monopolist: If he increases price, unit contribution (= profit per unit sold) increases but
demand decreases.
MR = P(1+ ) elasticity of demand = MR = P(1 - )
MR curve = a -2bQ (p=a-bq) (‘twice as steep’ rule)
- Amoroso-Robinson Relation: P*monopoly = MC x
- Lerner index: measuring market power = ability to set a price above cost (and get it paid …)
capability to make abnormal profits. =
Perfect competition L=0; sellers have no market power
Monopoly L is maximal; seller has the highest market power feasible in this industry
- PAGE 77
- The death weight loss = DIA 41
- Other costs of monopoly:
*Rent-seeking costs while obtaining/maintaining monopoly: e.g. too much spending on advertising,
product differentiation, excess capacity pre-emptively drives down profits of entrants (but has
no use for consumers)
*Expenditures for lobbying politicians to get preferential treatment (e.g. Wal Mart spent $6m on
lobbying in 2010)
*Without competitive pressure less incentives to innovate & produce efficiently (cf. X-inefficiency)
- Caution Against Demonizing Monopolies
*If a large firm’s LRAC decreases significantly as the quantity of output it produces increases, then it
would be inefficient to have output produced by many small firms Natural monopoly
*If an industry has high rate of technological change, static welfare comparison inappropriate,
better sacrifice some static efficiency for innovation (perfectly competitive firms have no
resources to invest in R&D)
*Perfect competition is not always feasible or even desirable. Inputs may be scarce.
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