INDUSTRIAL ORGANIZATION
Course description:
The course is concerned with three broad themes:
1. What determines the strength of competition? Among many important topics, we will discuss
market power, switching costs, the theory of firms, and mergers.
2. What are the main considerations for public policies or competition policies that affect markets
and firms? We will introduce some basic elements of competition policies including empirical
techniques and competition cases.
3. How new markets operate and how to build them? We will discuss two-sided markets, auction,
and market design.
Overview
Week 1 (Feb 16): Introduction of industrial organization + Models of competition
Additional reading:
Byrne, D.P. and De Roos, N., 2019. Learning to coordinate: A study in retail gasoline. American
Economic Review, 109(2), pp.591-619.
Week 2 (Feb 23): Market power and entry
Week 3 (March 1): Switching costs
Additional reading:
Klemperer, P., 1987. The competitiveness of markets with switching costs. The RAND Journal of
Economics, pp.138-150.
Klemperer, P., 1995. Competition when consumers have switching costs: An overview with
applications to industrial organization, macroeconomics, and international trade. The review of
economic studies, 62(4), pp.515-539.
Week 4 (March 8): The theory of firms
Holmstrom, Bengt R., and Jean Tirole. "The theory of the firm." Handbook of industrial
organization 1 (1989): 61-133.
Week 5 (March 15): Mergers
Additional reading:
Whinston, Michael. “Antitrust policy toward horizontal mergers”, Handbook of Industrial
Organization III, 2007, Elsevier.
Week 7 (April 19): Two-sided markets
Week 8 (April 26): Auctions and market design
Additional reading:
Agarwal, Nikhil, and Eric Budish. "Market design." In Handbook of Industrial Organization, vol. 5,
no. 1, pp. 1-79. Elsevier, 2021.
Klemperer, Paul. "What really matters in auction design." Journal of Economic Perspectives 16, no.
1 (2002): 169-189.
Pathak, Parag A. "What really matters in designing school choice mechanisms." Advances in
Economics and Econometrics 1, no. 12 (2017): 176-214.
1
, INTRODUCTION TO INDUSTRIAL ORGANIZATION
INTRODUCTION
What is Industrial Organization? It deals with
• How industries / markets work;
• How firms (imperfectly) compete with each other in these markets.
The study of “the causes and consequences of market power” – Jean Tirole
What is market power?
In short: The ability to charge a price above cost (production cost maar vaak ook marginal cost) without
losing all customers.
Case study:
• Zantac, the well-known ulcer and heartburn medicine produced by Glaxo Wellcome (now GSK),
was one of the largest-selling prescription drugs in the world.
• It costed relatively little to produce. However, the drug was sold at a high price.
Q: How could Glaxo Wellcome charge a high price without losing customers?
A: Relatively few substitutes → market power in the anti-ulcer and heartburn market (relatively small
market).
Q: If Zantac was so profitable, why have other firms not imitated it?
A: Glaxo Wellcome holds several patents...
- Entry into the market was not easy.
- Patents give market power (for the next 20 – 30 years)
- In fact, Zantac was itself a “me-too” drug, Glaxo managed to enter the market without infringing
Tagamet, introduced by SmithKline.
“me-too” drug: similar but not so similar drug (cleaver marketing team, similar working
components + extra to make it a ‘different’ drug, but in terms of function, it is the same)
- Glaxo maintained market power through the merger with Wellcome, which created synergy to
link R&D on similar drugs.
High market power is negative for consumers as they are forced to pay higher prices; therefore, policies
are needed.
What can policies do?
In US
• Competition policy was first introduced in the US at the end of 19th century
- Large improvements of transportation (e.g. railways) and communication networks paved way for
a single market
- Firms started to exploit economics of scale and scope, leading to price wars and the creation of
cartels and “trusts”
• The Sherman Act (1890) prohibits price agreements among competitors and covers monopolization
practices by firms; but it does not cover mergers!
• The Clayton Act (1914) covers merges that could reduce competition
• The Federal Trade Commission Act (1914) established the Federal Trade Commission (FTC) as a separate
enforcement agency for antitrust violations.
In Europe:
• Competition laws exist at both national and super-national levels
• Creation of European Common Market
• The Treaty on the Functioning of the European Union (TFEU)
- Article 101: cartels and restrictive vertical agreements
- Article TFEU102: abuse of dominant position
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, - Article 107: State Aid (might hurt competition if some firms have benefits)
- Merger Regulation (1989, 2004)
DG Competition is responsible for enforcement: https://competition-policy.ec.europa.eu/index_en
US vs EU: different focus
- US: fight against trust and cut out to protect consumers
- EU: stabilize prices post WW.
The role of Economics
The increasing role of economic arguments regarding
- submissions to European Commission (EC)
- decisions taken by EC
- guidelines (horizontal and vertical mergers, vertical restraints, market definitions, abuse of market
power,..) input from staff members: Chief Economist Team
A more economics approach
Emphasis shift of competitive assessment:
- away from “competitors’ harm”
- towards “competition harm to the detriment of consumers”
Competitive process:
- almost always results in harm to competitors
- is not necessarily harmed when competitors are harmed
- should serve consumers’ interests
Exclusion of competitors may result in anti-competitive effects and harm consumers
- example: exclusive contract between upstream and downstream firm
Objectives of this course
In this course, we will look at
- How firms compete or maintain their market power?
- How to measure market power?
- What are the roles and impacts of competition policy to avoid the negative effect as a result of
excessive market power?
- How (new) markets function?
We employ a dual approach that includes positive (how things are, explanation of facts) and normative
(how things should be, theories and welfare analysis) analysis.
Schedule of the course
3
, LECTURE 1. MICROECONOMICS REFRESHER: MODELS OF COMPETITION
How do firms (not) compete?
Firms maximize their profits.
• Monopoly: independent price setting behavior, no rivals. (extreme)
• Perfect competition: price taking behavior, firms are so small so that their actions have no impact
on their rivals. (extreme)
• Oligopoly: strategic, interdependent price setting behavior. (in between)
Oligopolistic competition
• Bertrand competition: competing firms determine on what price they would sell for a good;
• Cournot competition: competing firms determine on how much quantity to sell for a good.
Price competition: Example
Shared scooters at first sight, several companies (i.e. Bird, Lime, Poppy)
• Sell a homogeneous product: ride-sharing with scooters;
• Compete in prices:
Pricing game (niet in slides)
Q = 10 – p; MC = 1; possible set of prices = 2, 3 or 4. There are 2 or 3 firms. What price should you as a
firm set to maximize your profit?
Output outcomes Profit outcomes
A/B 2 3 4 A/B 2 3 4
2 4/4 8/0 8/0 2 4/4 8/0 8/0
3 0/8 3,5/3,5 7/0 3 0/8 7/7 14/0
4 0/8 0/7 3/3 4 0/8 0/14 9/9
Here: prices are continuous
BERTRAND MODEL
Consider two firms i = 1, 2
• Sell a homogeneous product;
• Simultaneously set prices and compete in prices;
• Have constant marginal costs (MC);
• Have unlimited capacity: when u undercut your competitor, you get more consumers and we
assume you can always supply this (increased) demand
• If firm 1’s price is lower than the price of the other firm, it attracts all market demand;
• If firm 2’s price equals that of firm 1, they splits the market equally.
• That is, firm i faces a (residual) demand curve:
Q: What pricing strategy is an equilibrium strategy?
Firm 1’s optimal strategy depends on what it thinks firm 2 would do, and vice versa.
Firm i’s best response (or reaction function) is a function pi∗ (pj ) that gives, for each price by firm j, firm i’s
optimal price.
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