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Microeconomics Industrial Organization
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Microeconomics Industrial Organization
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Microeconomics: Industrial organisationChapter 1 - What is industrial organisation?
Industry applies not just to manufacturing, but to any large-scale business activity. Industrial
organisation is concerned with the workings of markets and industries, in particular the way firms
compete.
While microeconomics focuses mostly on monopoly and perfect competition, industrial
organisation takes mostly the less extreme case of oligopoly. It’s economics of imperfect
competition.
The main questions of industrial organisation are:
-Do firms have market power?
-How do firms acquire and maintain market power?
-What are the implications of market power?
-What role is there for public policy with regard to market power?
Market power is the ability to set prices above costs, specifically above marginal cost.
In most industries, thanks to free entry and exit, market power is limited.
Market power can be acquired through legal protection from competition (patents), or
undercutting competitors in prices.
Market power implies greater firm profits and value, but from a policymakers’ point of view it’s
more complicated. Higher prices are considered bad when regulators place a greater weight on
consumer welfare than profits. Inefficient allocation is an unambiguously negative consequence of
market power though. Higher prices mean potential consumers refrain from consumption: Though
the value consumers derive is lower than the current price (meaning they won’t purchase) it’s
higher than the cost (with perfect competition they would purchase) causing a loss from the
absence of these sales due to the allocative inefficiency implied by market power.
A second harmful effect of monopolies is productive inefficiency since the costs increase due to
market power taking away incentives for increasing efficiency.
A third inefficiency is rent seeking: Unproductive resources being spent by firms to influence
policy makers. Think of the costs of lobbying.
Market power is good for firms yet bad for society. It makes firm owners richer at the expense of
consumers, decreases economic efficiency through allocative and productive inefficiency, and
induces firms to waste resources to acquire and maintain market power (rent seeking).
Public policy is to avoid the negative consequences of market power through regulation and
antitrust policy. Regulation is simply oversight on powerful companies. Antitrust or competition
policy is broader, preventing firms from taking actions to improve market power such as a AT&T’s
takeover of Time Warner.
The Chicago school of economics states that in a world of free competition, market power is
never significant and the only market power stems from government intervention: It takes an
opposite approach, stating that government intervention causes market power instead of market
power asking for the intervention of government. Milton Friedman argued antitrust does more
harm than good since they become prey to special interests.
Industrial policy is aimed at strengthening the market position of a firm or industry, namely with
respect to foreign firms: Think of the European government support for Airbus. Industrial policy
means governments picking winners, and is generally not liked by economists.
Chapter 5 - Sections 5.3 to 5.6
5.3 - Monopoly
Monopolists may exist because governments decreed them to, such as electricity companies.
Another example of government granted monopolies are patents or copyrights.
A second source is the nature of cost or demand functions, e.g. strong network effects.
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,Showing two industries with the
same demand and marginal costs
curve, but the one on the left has
many small sellers so is a
competitive market.
The one on the right is a
monopolist.
Under perfect competition,
equilibrium price is found at the
intersection of supply and demand: Pc and Qc, where the willingness to pay equals exactly the
marginal costs (since demand curve is the marginal cost curve in a competitive market.
All trades in a competitive market are such that the willingness to pay is greater than the marginal
cost: Every trade where willingness to pay exceeds marginal cost takes place, as all the points to
the left of Qc illustrate. All efficient trading takes place.
In the monopoly, equilibrium outcome is below the efficient level: Qm instead of Qc. All trades
between Qm and Qc fail to take place despite the willingness of buyers to pay at these trades
exceeds marginal costs. The value these consumers place on the purchase is greater than the
cost, implying an efficiency loss. This is the shaded area C which is the lost surplus p - MC from
missing efficient trades: The Harberger triangle.
The area C, the Harberger triangle, stemming from consumers not buying despite their willingness
to pay exceeding costs is called the allocative inefficiency or excess burden.
Another implication of market power is monopolies causing prices greater than marginal costs,
transferring from consumers to firms. A is relatively much smaller in monopoly.
Thirdly, monopolists are insulated from competition and therefore tend to incur X-inefficiency, a
loss of productive efficiency since output is not produced at the lowest cost possible since the
price is not the minimum of average costs.
Lastly, there’s rent seeking as a social cost of monopolies.
Aside from utilities, pure monopolies are rare but dominant firms are more common. An example
is AT&T which had 2 rivals with much smaller capacity but that were more efficient, allowing them
to set prices just below that of AT&T. AT&T
sets prices, and as long as they’re above
marginal cost the competitors will set prices
just below that and sell up to capacity. AT&T
then faces the residual demand Dr obtained
from subtracting total competitor capacity K
from market demand D.
Given residual demand, AT&T will act as a
monopolist on the Dr line and equate marginal
revenue with marginal costs and sell at PD. As
long as K is small, PD is close to PM the
monopoly price. A dominant firm behaves
similar to a monopolist, the higher the market
share (the lower relative K) the closer the price
to monopoly price. Therefore the monopoly
model provides a good approximation of
dominant firms.
Different market definitions lead
to different market shares:
Apple is a monopolist in
Macbooks, not in laptops.
There’s another problem with
monopoly definitions.
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,The firm on the left commands 90% of the market, the firm on the right 100% and is a pure
monopoly. Yet demand on the left is much less elastic, whereas demand on the right is more
elastic. Despite the firm on the right being an actual monopoly in definition, the firm on the left
charges a higher price thus has a higher market power.
5.4 - Regulation
Regulation is a government intervention in economic activity using commands, controls and
incentives.
Market regulation affects directly the workings of the price mechanism, e.g. subsidies or taxes.
Entry regulation such as licence requirements are rules determining market entry.
Firm regulation is a firm being subject to direct government oversight.
Social regulation includes automobile safety standards and equal opportunity employment.
The normative theory of regulation states that consumers are faced with the negative effects of
market failure and therefore demand regulation from their political leaders to protect them against
the negative externalities causing market failure, such as market power.
A more skeptical and perhaps more realistic perspective is that not consumers but firms demand
regulation: Think of a city limiting the number of taxi cab licenses, which keeps supply limited and
prices high. The capture theory of regulation views market regulation as a tool employed by firms
to better serve their own interests. Firms get away with capture theory regulation since the
benefits of such regulations are highly concentrated (cab owners) whereas the costs are spread
out over all consumers.
5.5 - Competition policy and antitrust
Competition policy is the European term for antitrust, which is more often used in the US. The
oldest and most common form are horizontal agreements such as price fixing.
Merger policy is to prevent excessive concentration of market shares. Sometimes dominance is
inevitable and antitrust authorities can only try to ensure the dominant firm doesn’t engage in
abusive practices.
5.6 - Firm regulation
Sometimes fixed costs are so large that a natural monopoly occurs. Scale economies are so
significant that the cost structure causes costs to be minimised with one supplier only.
Firm regulation of the monopolist may be the optimal solution.
If C = F + cq where F is fixed cost and c marginal cost, the monopolist will charge Pm without
equilibrium while the social optimum would be to set price at marginal cost. The difference
between marginal costs
and price gives us the
variable profit
π = qm (pm - c) so that
Net profit is π - F.
The regulator might
force the monopolist to
set price equal to
marginal costs: PR = c,
where R stands for the
regulated price. Output
is then QR and
maximum allocative efficiency is achieved. This however means negative profits for the firm:
When variable profit π is zero, total profit is -F.
The regulator must give a subsidy F to make it survive, but this means raising taxes elsewhere
which could offset the efficiency gains.
It also increases the opportunities for regulatory capture: A situation whereby firms invest
resources into influencing the regulator’s decisions to the point that regulation reflects the
objective of profit maximisation instead of welfare maximisation. So marginal cost pricing is
difficult.
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, Average cost pricing is a regime forcing the firm to set the lowest price consistent with non-
negative profits: Price equals average costs, as seen in the right panel. This is an intermediate
between an unregulated monopoly and marginal cost pricing which makes negative fixed costs as
firm profit.
The US often uses rate-of-return regulation which sets prices as such to allow the firm a fair rate
of return on the capital it invests, roughly corresponding to average cost pricing. Rate-of-return
regulation though gives firms very little incentive for cost reduction: Lowering costs implies the
allowed price will be lowered, giving the firm the same rate of return.
There’s a regulatory lag though: A gap between the time when costs are reduced and the new
regulated price takes effect, which may provide some transitory incentives for firms to lower
costs. The rate-of-return regulation is still fundamentally flawed w.r.t. cost reduction though.
It’s a low-power incentive mechanism: Price varies in the same measure as cost, which minimises
incentives for cost reduction.
A high-power incentive mechanism sets price beforehand and doesn’t change it when cost
changes. Such a price cap regulation provides maximal incentives for cost reduction, since 100%
of cost savings result in profit increases.
In reality though, a high-power incentive mechanism acting as a price cap regulation can’t ignore
large cost reductions over long horizons. Regulators will after a certain number of years probably
still decrease the price cap, making the high-power incentive mechanism act as a rate-of-return
regulation with a very long lag.
A second problem is that when prices can’t increase due to price cap regulation coming with
high-power incentive mechanisms, firms have little incentive to increase quality and may even
reduce it, increasing the price per unit of quality.
Determining a price cap is also difficult, since a very high one implies allocative inefficiency of a
price exceeding marginal costs and a transfer from consumers to monopolist. A very low price
cap may cause the regulated firm to go out of business.
A high-power regulation mechanism provides strong incentives for cost reduction but little for
quality provision. It also implies high risks for the firm.
The best way to recover allocative efficiency lost under monopoly pricing is competition. When
not feasible, regulation is the second best alternative. Whether or not a monopoly is natural is
subject of discussion: Though a network for electricity transmission surely is a natural monopoly,
generation is not. The problem is that one part can’t independently exist from the part that is a
natural monopoly: An electricity generator is dependent on the distributor.
So the monopolist (network) sells services to firms in the competitive segment (generation) who in
turn sells to costumers. The monopolist is an upstream bottleneck since his assets or output are
an essential facility.
An airport for example is an essential input for transportation services into a certain city. While
there are many competing downstream firms (airlines) the upstream firm is the bottleneck.
Often the stream essential facility also competes downstream, e.g. the network owner also
operating a telecoms company.
Most upstream firms are allowed to compete downstream but prevented from discriminating
against downstream competitors. Regulators might regulate the access price: The price paid by
downstream firms to access the essential facility, e.g. limit the price the airport can charge
airlines.
The Efficient Component Pricing Rule ECPR maximises production efficiency since it only allows
the independent downstream firm to survive if they’re competitive with respect to the vertically
integrated firms. The price the integrated firm charges the independent firm equals its own final
product price minus its marginal costs at most. That way the independent firm can only compete
when its marginal cost is the same or lower than that of the firm owning the essential facility.
As with many other instances of industrial organisation, there’s a trade-off between efficiency and
market-power: Some mergers are likely to increase efficiency and innovation.
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