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Industry Empirical Studies NEIO and Industry Models of Market Power

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Title: Industry Empirical Studies NEIO and Industry Models of Market Power


1
IndustryEmpirical StudiesNEIO and Industry
Models of Market Power
Based on the lectures of Dr Christos Genakos
(University of Cambridge)
2
OUTLINE
  1. NEIO and the Structural Approach
  2. Identification
  3. Estimation and Hypothesis Testing
  4. Examples Porter (1983) Genesove and Mullin
    (1998)
  5. Reduced form and Non-Parametric approaches

3
New Empirical Industrial Organization (NEIO)
  • Most important weakness of the SCP paradigm was
    the lack of feedback mechanisms emphasized by
    game theory
  • Structure, Conduct and Performance are jointly
    determined by underlying primitives,
    institutional details and equilibrium assumptions
  • Two important lessons during the 70-80s every
    industry has many potentially important
    idiosyncrasies and these details matter a lot for
    the predicted conduct and performance
  • Perhaps we should abandon the hope of finding
    common patterns across industries and instead
    look at each industry more carefully


4
New Empirical Industrial Organization (NEIO)
  • Key features of NEIO
  • No use of accounting data for costs and
    price-cost margins
  • Estimate market power fore each industry
    separately
  • Behavior of firms is estimated based on
    theoretical oligopoly models. This allows for
    explicit hypothesis testing on the degree of
    market power.
  • The degree of market power is identified and
    estimated. The inference of market power is based
    on the conduct of firms.


5
The Structural Approach
  • Suppose you had data on the following homogeneous
    goods market
  • P industry price
  • qi output for each firm and Q the whole industry
  • Y variables that shift the demand curve (income,
    weather, price of substitutes)
  • W variables that shift the supply curve (price of
    inputs, weather, technology)
  • Could you uncover the extent of market power?
  • YES! Use the data to simultaneously estimate the
    elasticity of demand, marginal costs and firm
    conduct!


6
The Structural Approach
The key aspect of this approach is that it uses
theory to specify the structure of demand and
supply and in the process firm conduct is
identified (pure magic!) Lets see how Demand
function Supply function Profit function

7
The Structural Approach
Marginal cost Marginal Revenue ?i is a
parameter which measures conduct ?i0 price
taker, ?i1 Cournot, ?i1/si Monopoly. Optimality
Condition gives us the supply relationship

8
The Structural Approach
Two interpretations of ?i parameter (i) measures
the gap between price and marginal cost, and (ii)
an aggregate conjectural variation Problem
with interpretation (i) can justify only few
values, not a continuous index Problem with
interpretation (ii) Corts (1999) critique that
estimation of ?i only unbiased if underlying
method is the result of a conjectural variations
eq. underestimate if firms collude
Mkt Structure ? L
Competition/Bertrand 0 0
Cournot 1 -si/e
Monopoly (collusion) 1/si -1/e

9
OUTLINE
  1. NEIO and the Structural Approach
  2. Identification
  3. Estimation and Hypothesis Testing
  4. Examples
  5. Reduced form and Non-Parametric approaches

10
Identification
Can we identify the market power parameter ?i
given only market level data on P, Q, Y and
W? Remember our supply function
is Identification Problem is that Q and P are
equilibrium values, simultaneously determined by
the interaction of consumers and firms

11
Identification
To trace the supply equation we need variables
that shift the demand curve (like income) but not
the supply relationship

12
Identification
Similarly, to trace out the demand curve we need
variables that shift the supply (like wages) but
not the demand relationship
13
Market Power Identification
Hence to identify demand (supply) function, we
need at least one exogenous variable in the
supply (demand) relationship that does not enter
the demand (supply) function. What about the
market power? Assume demand is given
by (1) Assume also that marginal cost (not
observable) is given by (2) Hence, supply
relationship is (3)

14
Market Power is NOT Identified
Shifting only the intercept of the demand curve
does not identify market power

15
Market Power IS Identified
Shifting ???? the intercept and the slope of the
demand curve identifies market power

16
Market Power Identification
Hence, using econometric estimates of the demand
and supply parameters (equations 1 and 3) we can
obtain an estimate of the degree of market power,
in our example here Note identification is
based on (arbitrary?) assumptions on the
functional form of both the demand and marginal
cost functions. Note If we assume constant
marginal cost, we can estimate the degree of
market power! Without shift in slope!!!

17
OUTLINE
  1. NEIO and the Structural Approach
  2. Identification
  3. Estimation and Hypothesis Testing
  4. Examples Joint Ex Committee Genesove and Mullin
  5. Reduced form and Non-Parametric approaches

18
Estimation and Hypothesis Testing
  • Given a set of credible instruments, the
    econometrician estimates the demand and
    optimality condition either separately (2SLS) or
    as a system (3SLS, GMM) of equations
  • Two ways to estimate the market power parameter
  • Estimate it as a free continuous variable. One
    then tests whether ? equals a value associated
    with a well-known model of competition (Bertrand,
    Cournot, collusion)
  • Estimate separate models corresponding to the
    various well-known models by imposing the
    particular value of ? and then use non-nested
    tests to choose among them


19
OUTLINE
  1. NEIO and the Structural Approach
  2. Identification
  3. Estimation and Hypothesis Testing
  4. Examples Joint Ex Committee Genesove and Mullin
    (1998)
  5. Reduced form and Non-Parametric approaches

20
Genesove and Mullin (1998) conduct and cost in
the sugar industry, 1890-1914
Genesove and Mullins aim is to test the validity
of the NEIO methodology by comparing the
estimated conduct parameter from a structural
model to the calculated price-cost margins in the
sugar industry The simple production function
together with its volatile history of high
concentration, price wars and court cases at the
beginning of the century make this industry the
ideal test ground Why should an industrial
economist care about the answer?

21
The Sugar Industry and Production Technology
The industry during period of study is
characterized by high levels of concentration,
episodes of entry and price wars and later
acquisition by or accommodation with
ASRC Refined sugar is a homogenous good with
common technology

22
Demand and Structural Model
The postulate a general demand formula that
encompass as special cases the quadratic, linear,
log-linear and exponential Optimality condition
for a constant marginal cost, c, and conduct
parameter, ?, is given by Instruments used
Cuban raw sugar imports, which are driven by
harvest cycle, weather conditions, Cuban
Revolution, Spanish-American War

23
Supply Equation and Results
  • Substituting marginal cost function into pricing
    rule gives us
  • Genesove and Mullin estimate different versions
    of their model depending on the demand function
    but also cost information availability
  • Results
  • NEIO methodology does pretty good tracking
    calculated price-cost margins independent of the
    assumed demand function, although ?
    underestimated
  • Cost estimates sensitive to the model assumed,
    predictive power improved when add real info even
    if model misspecified
  • Estimating a free conduct parameter improves
    estimates


24
OUTLINE
  1. NEIO and the Structural Approach
  2. Identification
  3. Estimation and Hypothesis Testing
  4. Examples
  5. Reduced form and Non-Parametric approaches

25
Reduced form and Non-Parametric approaches
An alternative method to a full structural model
is to use comparative statics and be able to
distinguish firm behaviour Good alternatives if
important concerns on specification of structural
model or data limitations Basic idea suppose
that firms face a constant marginal cost a shock
causes the marginal cost to rise. If the market
is competitive, the price will increase by the
same amount as mc. If the market is
oligopolistic, price will not change by the same
amount. Again we need to specify a demand
function and functional form will matter for the
results, but in principle we require less info
than a full structural model However, by imposing
less structure we are able JUST to test whether
the market is competitive or not, cannot measure
the degree of market power

26
NEIO and Industry Models of Market Power
References
Bresnahan, T. (1982) The Oligopoly Solution is
Identified, Economic Letters, 10
87-92. Bresnahan, T. (1989) Empirical Studies
of Industries with Market Power, Handbook of
Industrial Organization, 1011-1057. Corts, K.
(1999) Conduct Parameters and the Measurement of
Market Power, Journal of Econometrics,
88227-250. Genesove, D. and Mullin, W. (1998)
Testing Static Oligopoly Models Conduct and
Cost in the Sugar Industry, 1890-1914, Rand
Journal of Economics, 29355-377. Graddy K.
(1995) Testing for imperfect competition at the
Fulton Fish Market, Rand Journal of Economics,
2675-92.

27
Next time Differentiated Products Structural
Models
Berry, S (1994) Estimating Discrete-Choice
Models of Product Differentiation, Rand Journal
of Economics, 25242-262. Hausman, J. (1997)
Valuation of New Goods Under Perfect and
Imperfect Competition, in Bresnahan and Gordon
eds., The Economics of New Goods, NBER. Nevo
(2001) Measuring Market Power in the
Ready-to-Eat Cereal Industry, Econometrica,
69307-342. Nevo (2000) A Practitioners Guide
to Estimation of Random-Coefficients Logit Models
of Demand, Journal of Economics and Management
Strategy, 9513-548. Berry, S., Levinsohn J. and
Pakes, A. (1995) Automobile Prices in Market
Equilibrium, Econometrica, 63841-890.
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