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Economics of industry

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Title: Economics of industry


1
Economics of industry
  • The economic consequences of market power, the
    foundations of industrial policies

2
Intro
  • The economic consequences of the size/ scope of
    firms, of the structure of markets, of the
    existence and exercise of market power.
  • The economic consequences of the firms search
    for, use and protection of market power.
  • The S-C-P (mainstream textbook) view of the
    world, some alternative views, evidence and
    interpretations.
  • A deliberately critical evaluation. Economics is
    about learning how to think not what to think.

3
References etc
  • For outline/ suggested textbook/ and references
    see class guide. Remember I am not following the
    textbook closely. The textbook is complementary
    not a substitute. It has a lot more detail than I
    can present in the lectures. It should be pretty
    obvious where to look for extra details in the
    textbook for the issues as they arise so only
    from time to time will I refer specifically to
    the textbook.
  • NB there are some supplementary word based notes
    ( one on market power, one on oligopoly etc) as
    well as the lecture slides on the web pages.

4
LW text
  • Chap 1.2 (views of competition),
  • 2.5/ 2.6 (basics of case for competition),
  • 10.3 (price discrimination and significance),
  • 14.2 (Arrow model and innovation)
  • and 17.2 and 18.2 (more on basic case against m
    power)

5
Parts
  • A. The problem outlined the monopoly model,
    monopoly power, and economic efficiency
  • B. The debate started examining the foundations
    of the mon. model
  • C. The debate continued beyond monopoly.
    Oligopoly models, cooperative and
    non-cooperative, and what these tell us about the
    consequences of market power
  • D. The evidence considered statistical evidence
    on the effects of market power and the
    interpretation of the evidence
  • E. Other aspects consequences re vertical
    integration/ MAs discussed later

6
Economic consequences of firm s/e/p market power
?
  • For firms profits (private interest)
  • For economic efficiency broadly defined (social/
    public interest)
  • And the idea of a social welfare loss from
    monopoly and oligopoly (m power).
  • Including consequences of actions such as
    vertical restraints and MAs?

7
Watch the words
  • What firms are actually seeking for is economic
    profit or economic added value (EVA) but
    mainstream texts on IO focus exclusively on
    market power as the means to achieving this end
    so it is these means which they investigate and
    condemn. Other possible sources of success, such
    as entrepreneurial insight, innovation, or
    superior organisation qualities, arent even
    considered. Firms dont succeed because they are
    good at what they do but because they acquire and
    exploit market power.
  • As we will argue later this is both strange and
    questionable. It seems to assume something about
    the determinants of business performance, of the
    sources of business profit, rather than treating
    this as an issue to be investigated.

8
Focus issues
  • How satisfactory is the economic case against
    market/ monopoly power as a foundation for public
    policy actions against dominant firms, collusion,
    mergers, etc. In particular how good is the
    evidence.
  • Contrasting two schools of thought the
    mainstream Harvard SCP school and its Chicago
    school critics.
  • Leads us to a consideration of competition policy
    itself.

9
Competition policy
  • In this report comp policy is used as a
    convenient term to cover the policy on
    monopolies/ mergers/restrictive practices/resale
    price maintenance/ and other uncompetitive
    practices. The criterion for action is the
    public interest defined in terms of industrial
    efficiency
  • Government Review of Monopoly and Merger
    Policy, 1978
  • This tells us what C policy is about and its
    underlying objectives.

10
  • Com Pol is an element of wider government
    involvement in the economy called industrial
    policy which is concerned in principle with
    state efforts to improve overall economic
    performance by, it is hoped, making the economy
    more dynamic and efficient.
  • Gov cannot do this directly, by dictation, so it
    has to approach it indirectly by acting on the
    business environment (promoting competition) and
    on the actions of firms seeking market power.

11
Assumption
  • On which policy rests is that there is a direct
    and significant link between (market)
    Structure-(firm) Conduct and (market) Performance
    (efficiency). Hence SCP school. The
    theoretical basis being the Harvard school of
    industrial economics as developed by Bain, Caves,
    Porter et al.
  • But these views are not universally accepted.
    Some, more sceptical, economists believe there is
    no really satisfactory verifiable basis for c
    policy, that it could end up doing more harm than
    good.

12
Some minority views
  • There is also a (perhaps extreme) minority view
    (liberalism) which promotes competition as an end
    in itself, not just as a means to industrial
    efficiency. This would promote more competition
    even if this damaged industrial efficiency (eg
    Charles Rowley). Belief is that dispersed
    economic power is vital to democracy and personal
    responsibility and thus is opposed big business
    power in principle.
  • At other extreme are those who think monopoly is
    fine as long as it is socialised and publicly
    owned. Belief here is that m is ok if it seeks
    the public interest rather than profit. Once
    official UK labour party policy. The labour party
    has usually been perfectly happy to promote
    public monopoly whilst attacking private monopoly
    as exploitative. In fact a lot of competition
    policy in this country has been developed under
    labour governments.

13
Part A The problem outlined
  • Problem with which c policy seeks to deal is the
    presumed socially detrimental consequences of a
    firm or a group of firms seeking and using market
    power.
  • The detriments are believed to arise as a result
    of economic efficiency losses which theory
    suggests are associated with market power and the
    (damaging) efforts of powerful firms as they seek
    to extend/ exploit/maintain their power. The
    problem has two aspects
  • 1. The monopoly or dominant firm problem
  • 2. The collusion or restrictive practices
    problem (cooperative cartels/ collusive
    tendering) sometimes referred to as a complex
    monopoly.

14
The case against m power and for more competition
  • Is that in general it harms economic efficiency,
    broadly defined, compared to competitive
    structures (we take knowledge of the competitive
    model as given here).
  • The case against covers allocative effic,
    organisational effic, and dynamic efficiency (and
    some other complaints such as wasteful
    advertising).

15
NB
  • The case against market power is developed from a
    comparison of two simple extremes (pc and m).
    The implication being that if monopoly is bad
    and (p) competition is optimal anything
    increasing market power is suspect and anything
    that increases competition is good.
  • Thus is it that in some countries monopoly is
    often thought to become a problem when a dominant
    firm has 25/30 of a relevant market. We will see
    later under oligopoly theory that what happens in
    between the extreme models is much more
    complicated than that.

16
Allocative efficiency
  • The key argument in theory. The traditional
    simple textbook comparison of good competition
    against bad monopoly. Under a long list of
    strictly defined conditions (to be examined
    later) we get
  • P gt MC,
  • Lower output produced, (compared to pc)
  • Private super-normal profits (which is the
    incentive), and
  • There arises a net or deadweight loss of social
    welfare measured in terms of consumer surplus and
    called the Harberger triangle. See diag for
    details of these effects.

17
Harberger triangle?
  • After Arnold Harberger, a Chicago economist.
  • Who in fact was critical of mainstream m theory
    and developed his famous triangle idea as a tool
    for identifying and estimating the size of the
    harm from monopoly. We discuss later, under
    evidence, his initial finding which was that
    these losses were in fact rather trivial! And of
    course the many follow up studies which have
    supported or sought to challenge this initial
    finding.
  • This is how economics works idea, challenge,
    response, improved understanding.

18
Monopoly and alloc. efficiency
  • Diagram one (at lecture)

19
Organisational efficiency
  • Idea here is that the absence of competitive
    pressures causes employees to slacken off their
    pursuit of cost efficiency. Thus employees
    indulge in effort relaxation, excessive expenses,
    big offices, lots of personal assistants, etc.
  • Which causes overall firm cost levels to rise and
    exacerbates the impact of market power.
  • Redraw diagram one and allow for higher level of
    costs, check outcome. How much worse is it?
  • Commonly called X efficiency after Leibenstein
    (Harvard) who coined the term

20
Organisational effic
  • Diagram two

21
But
  • Owners/ managers can in principle invest in
    greater effort to control organisational
    inefficiency and keep costs under control.
    Monitoring and enforcement efforts. Carrots like
    bonuses, sticks like foremen/ supervisors.
  • But to the extent that these extra efforts cost
    more than under comp conditions then these costs
    can be seen as a resource waste of monopoly.
    So even if a monopolist looks reasonably
    efficient there may still be harmful consequences
    because of the extra efforts needed to achieve
    this outcome.
  • Competition is being seen here as a cheaper
    device for generating discipline and promoting
    organisational efficiency.

22
Dynamic efficiency (innovation)
  • It is argued that competition not only forces
    firms to be cost efficient, it also forces them
    to be innovative, to be dynamically eff, if they
    wish to maintain their competitiveness or to
    escape from the pressures of comp markets and
    earn some above normal profits.
  • Under mon it is argued that the incentive to
    innovate is inevitably reduced. The mon already
    earns nice profits and this implies a naturally
    lesser incentive to innovate. (The profits of
    innovation less current profits basically). But
    NB the mon still has an incentive to innovate.

23
Arrows model
  • There is an influential simple formal model which
    purportedly demonstrates this (intuitive?)
    result, called the Arrow model (after Kenneth
    Arrow). It is in the textbook (eg George) along
    with the long debate it ignited.
  • The model is arguably a bit naïve (even George
    says it strains credulity) because it examines
    only the motivation of comp firms to adopt a new
    idea (rather than to seek it out in the first
    place) and so ignores the issue of the ability to
    undertake investment in RD and innovation.
    Which may be even more important. We examine the
    issue more fully later on.
  • NB I say arguably naïve, in view of the fact that
    Arrow won his Nobel prize for ideas like this!
    Respect!

24
A paradox?
  • Also, is there a paradox or a puzzle here?
  • Competition creates incentives for innovation (so
    it is argued) often because it offers the
    prospect of monopoly profits! ie it offers an
    escape from competition. But if mon is harmful,
    couldnt the competitive incentive to seek one be
    seen as harmful or wasteful? (see the Posner bit
    later)

25
Monopoly and product quality
  • Argument (more advanced) that monopoly will
    tend to harm product quality, since firm has less
    incentive to promote the socially optimal level
    of product quality.
  • Quality choice for the profit seeking monopolist
    will lead to an outcome where marginal cost of
    improving quality is equated with the marginal
    revenue from the provision of higher quality.
  • As long as producing better quality is privately
    profitable it gets produced. But .

26
Never mind the quality..
  • But it is argued that the production of quality
    by the mon will be socially sub optimal. The
    socially optimal level of quality is at the point
    where the marginal social cost of producing
    quality equals the social marginal benefit of
    quality (as measured by willingness to pay, or
    price) which would be chosen say by a benign
    socialist monopolist (who exists in the
    textbook only).
  • What is not clear however is whether private
    profit seeking competitive firms will produce the
    optimal quality outcome either.

27
Quality diagram
  • Diagram 3

Value of increases in quality
Quality
28
Quality range
  • It is argued further that a comp market will
    encourage a full range of quality, say from
    cheery but cheap at the bottom to exquisite but
    expensive at the top as competitive firms seek to
    fill the available market space.
  • Whilst the monopoly will not provide a full range
    of offerings. It will produce enough at the top
    of the range but not at the bottom. The logic is
    it will seek to push more consumers up market
    and thus wish to reduce the possibility of
    consumers buying at the lower end.

29
Is this suspicious?
  • If a comp firm fills each quality space
    available wouldnt it then have a monopoly for
    producing that quality of product? Paradox?
  • Textbooks use airlines for example, arguing that
    the difference between 1st class, and no class is
    an example of the issue. But how would
    competition (or a benign monopolist) work here?
    A first class flight only, a second class, and so
    on?

30
Posners extension
  • Richard Posner argues that since monopoly is
    valuable competing firms will invest resources in
    searching for monopoly situations. (Also called
    rent seeking in some texts). Indeed you could
    say that competition is often the search for
    monopoly.
  • Thus firms may invest in efforts to encourage gov
    to regulate competition (in airlines or banking),
    to restrict imports, to provide lengthy patent
    rights,
  • And invest in RD, advertising, acquire
    competitors, etc to win and maintain m power.

31
Posner cont.
  • How much will firms invest in the search for mp?
  • Posner argues that firms will invest (in total)
    as much as the expected (capitalised) mon
    profits! (Its a bit like a lottery game)
  • Hence he suggests that this competition to become
    the monopolist is potentially just as socially
    wasteful as having a monopoly so that the
    costs of monopoly are arguably much greater
    than Harberger had originally suggested. It is
    Harberger triangle plus the private profit
    rectangle now.

32
Posner cont.
  • Why? Because although the winner appropriates
    some nice juicy profits after paying of its
    costs, if you net out the costs to society of the
    various efforts that everyone else put in to
    winning then overall we are no better off in
    total! And the efforts are measured by the
    expected profits of winning.

33
Why like a lottery?
  • Cause in total we all subscribe a lot more to the
    lottery than in total we can expect to win back!
  • In fact each week we (in total) get back in
    prizes only half of what we pay for the tickets
    we buy!
  • In this sense competition to win big prizes leads
    us to considerably oversubscribe (or over-invest)
    cause we rate our own chances of winning too
    highly (we behave irrationally). And this is
    potentially inefficient or wasteful socially
    with respect to say RD competition.

34
  • But this suggests that competition is the problem
    not monopoly and where does this logic lead?
    Publicly owned monopolies perhaps (the old LSE/
    labour view)?
  • It is indeed possible sometimes to see
    competition in a not so benign light. For
    example choice can be nice but it can become
    confusing not to say overwhelming. Been to Comet
    to buy a TV recently? Indeed competition can be
    a nuisance sometimes. Buses clogging the streets.
    Crowded airports. Double glazing salesmen
    phoning you. Newspapers with more adverts than
    news. TV advertising. Who needs it?
  • Or might it be poss to distinguish good
    (socially beneficial) competitive efforts from
    the not so good?

35
Good v bad competition?
  • Eg advertising is a comp weapon. If adv provides
    us with useful information it is valuable
    (efficient) socially but if it is mostly
    persuasive (encouraging brand jumping a la
    Coke/Pepsi) or builds entry barriers it is
    arguably not so good socially. Gets a bit
    difficult however.
  • Who is to judge what is useful info and what is
    harmful persuasion? Maybe we enjoy being
    persuaded? And herein lies scope for quite
    different interpretations of the relation between
    market profitability and firm behaviour. The
    mainstream harmful view that any above
    competitive level profits is due to m power,
    and the more benign competitive advantage view
    that it is due to superior capabilities and
    competencies to be considered later.

36
Posners analogy
  • Is along the lines that the true economic cost of
    crime is not measured by the goods stolen but
    include the cost of resources devoted to crime
    and its prevention. Which may be reasonable.
  • But the analogy of efforts to beat the
    competition with criminal activity may be less
    reasonable. To say that efforts to build a brand
    or to innovate are anti-social in the way that
    bank robbery is seems to be stretching it a bit.
    Even lobbyists are not necessarily anti-social.
    There is such a thing as unfair foreign
    competition or unfair infringements of property
    rights and it is legitimate to complain about
    them.

37
Call that a case?
  • So thats the essence of the harmful case.
    Question is, how good a case is it? Is it as
    strong as mainstream textbooks suggest? How good
    is the empirical and case evidence on these
    things? Is there another more benign way of
    looking at firm behaviour and excess profits?
  • This is what we seek to consider next.

38
Part B. Debating the foundations
  • A closer look at the foundations/ assumptions of
    the mainstream view (see any standard chapter on
    monopoly model). Aim here is to show that the
    standard results depend on a number of arguably
    extreme and possibly questionable assumptions.
  • NB not aiming here to show m power is actually
    good for us, simply to suggest that it is not so
    easy to demonstrate convincingly that it is
    harmful in practice.
  • Assumptions (1,2,10) examined in turn.

39
1. Only one firm in the market
  • Therefore no possibility of rivalry, no
    interdependence, of any sort. Firm is a price
    maker pure and simple.
  • Because once any rivalry exists (as oligopoly or
    even fringe competition) the results get harder
    to predict as we see later. But one result is for
    sure the social harm of m power declines
    depending on the precise characteristics of the
    oligopoly in question. A key issue becomes the
    possibility of sustainable collusion which as we
    will see later is harder than it seems.
  • NB also empirically speaking absolute 100 mon
    is not common, except when granted by the state!
    Dominance is more common (big businesses with
    substantial m shares, say 50 ) but thats a
    different game!

40
2. No close substitutes
  • For the monopolists product/ service.
  • Because if there are, the (harmful) power to
    raise prices above marginal costs diminishes.
  • The availability of subs affects the position and
    elasticity of the market demand function. And
    elasticity is a crucial determinant of the
    harmfulness of monopoly result. It enters into
    calculations of the size of the Harberger
    triangle (see evidence part).
  • For example there is only one Euro-tunnel but the
    subs (ferries, planes) seem to be close enough to
    constrain it quite effectively. In fact it loses
    lots of money! And so do some of the
    substitutes!

41
Elasticity of demand significance
  • Recall the definition and significance from
    earlier classes. And the precise relation
    between elasticity and total and marginal
    revenue. NB also the profit seeking monopolist
    always prices where elasticity exceed one. Why?
  • Note that since the m price is where demand is
    elastic there must be substitutes available to
    produce that result.
  • Note also how the size of elasticity (e)
    (2,3,4,5) determines the exact divergence of
    monopoly price from cost.
  • Look up the Lerner index which formally
    expresses this relationship. As e increases the
    price-cost margin falls.

42
Substitutes and containers
  • Lets say there was one firm producing all the
    glass bottles, one producing plastic, one doing
    aluminium cans, one doing tetra pak cartons etc.
    Does this mean four harmful monopolies or a
    differentiated competitive oligopoly market?
  • Are Coca Cola and Pepsi monopolists or do they
    produce very close substitutes? What about CC and
    Perrier? Or CC and coffee?
  • Point is, it is a matter of degree. Ultimately
    everything is competing with everything else for
    the consumers dollars (and other resources).
    Drawing neat boundaries and calling them
    markets is more difficult than it appears.
    What is the software market? The drinks market?
  • Although identifying industry bounds is easier
    cause this is defined in terms of production
    technology (glass bottles and aluminium cans) not
    competing substitutes.

43
Monopolistic competition
  • In fact the so called mon comp model is often
    construed as harmful as well. This is a model
    with all the characteristics of perfect comp
    apart from homogeneous products. It allows for
    the existence of slightly varied or
    differentiated products which are very close, but
    not perfect, substitutes. So there may be a lot
    of competition, but it is amongst small
    monopolies. For ex, there are lots of cafes in
    Paris but some are nearer your hotel than others
    and none of them are exactly the same. This is
    thought to be harmful because in equilibrium
    prices are shown to diverge from marginal costs.
    So the result isnt quite that of the perfect
    competition model where price equals m costs.
  • But so what? If people like variety, if they
    value distinctiveness, and are prepared to pay
    slightly higher than perfectly competitive
    prices, who are we to call it harmful? Would we
    be better off if every café was exactly the same?

44
How extreme an assumption?
  • In the SR perhaps not so extreme.
  • But in the longer run it is extreme for the
    simple reason that the existence of mon profits
    will encourage the development of closer
    substitutes. So the question for the monopolist
    is how long will this take? (And what can it do
    to slow it down?) If it seems technologically
    unlikely the mon can rest easy. But technology
    has a way of surprising us. Need I mention the
    internet?
  • This is important because harmfulness is related
    to longevity. Short lived mons are not a big
    problem.

45
New economy critique of MP
  • A group of authors/consultants argue that the
    nature of new economy (1990s style) makes
    market power less sustainable than ever.
  • Consultants such as McKinsey (creative
    destruction), PWC (continuous transformation),
    and authors such as Prahalad-Hamel (competing for
    the future), DAveni (hyper-competition), Wood
    (complexity) and Brown-Eisenhardt (competing on
    the edge) and Mendelson (organisation IQ) all
    argue basically that profits are increasingly
    transitory, temporary, short lived, and
    impossible to sustain.
  • A composite view of these authors is next.

46
Comp in the new economy
  • All profits are transitory. They always attracts
    competition and get squeezed. Success (?)
    generally comes from attack not defence. No
    business can stand still. Not even a Microsoft.
    Success needs to be constantly renewed by
    continued investment efforts. This depends on
  • Creativity, innovation, newness, surprise,
    initiative, flexibility, speed of reaction,
    decisiveness, opportunism, anticipation,
    reinvention, organisational intelligence,
    identifying and exploiting the right options,
    energising the business.
  • That is on developing and using competitive
    capabilities to produce a competitive advantage,
    not on static mon power.

47
Note on semantics
  • Industry is an unsatisfactory term.
  • It is ok for some purposes to talk of the hotel
    industry, the publishing industry, the auto
    industry. But it is imprecise.
  • Competition is about specific markets not
    industries. Think of industries such as hotel,
    publishing, auto, education, finance,
    pharmaceuticals? In hotels we have luxury hotels,
    mid range hotels, cheap and cheerful,
    backpackers. (US/EC/SEA etc) In drugs, there is
    no single market, but dozens of distinctive
    markets relating to particular problems.
  • Point? Competition is about reasonably well
    defined distinctive markets for particular
    customer segments in particular places.
  • In autos it is true in general that Ford
    competes with VW. But even here the important
    action is in well defined market segments (small
    cars say) in particular areas (UK).

48
Defining the market
  • Anti-trust authorities need to be able to define
    relevant markets and this can be difficult.
    Essentially what they wish to identify is a
    situation in which a hypothetical monopolist
    could raise prices significantly and sustainably
    (say over 5 for a year). To do this they need to
    consider the demand side, supply side and
    geography. SEE also LW on this, chap 6.2

49
  • On demand side they would consider the extent to
    which consumers perceive products to be
    substitutes. If oranges are considered a very
    good sub for apples but not for bananas then o/a
    are part of the same market but bananas are not
  • On supply side they would consider how easy it
    might be for producers to switch production
    between goods. For example if a cola bottler can
    switch to bottling water with ease but not milk
    then the first two are closer subs.
  • On geography they would consider whether a
    hypothetical monopolist could sustain a price
    rise in region x. If so, that is the relevant
    market, if not, define a bigger region until the
    answer is yes.

50
NB
  • A monopolist will set price where demand is
    elastic, where subs begin to make their presence
    felt. So the existence of subs for a mon market
    it is argued doesnt per se indicate there is
    enough potential competition at present. The
    question should be, would there be any serious
    subs at the comp price in the relevant market?
    If not, then the market is effectively
    monopolised.

51
In practice
  • Needless to say in practice defining the relevant
    market is one of the most contentious areas of
    comp policy. The authorities will tend to seek a
    narrower definition than producers.
  • Take newspapers. What market is the Sun part of?
    Tabloids only, or all national newspapers and
    news magazines? What about free newspapers and
    local newspapers? What about TV news programmes?
    And nowadays the internet? Plenty of scope for
    arguing.
  • Try the market for alcoholic beverages.

52
3. Entry is blocked
  • Potential rivals find it unprofitable to enter
    the market to take on the profitable incumbent so
    no need for incumbent to make allowances for this
    possibility despite there being incentives to
    enter, in the form of the profit opportunities.
  • Again possibly an extreme assumption in the long
    run although it is true that incumbents have
    incentives to actively invest in the creation of
    entry barriers to seek actively to discourage
    rivals (more details on this later under
    oligopoly).

53
Extreme? Consider
  • The many markets that had very powerful
    incumbents and apparently very high barriers to
    entry that eventually succumbed to successful
    entrants.
  • The US auto industry pre Japanese invasion, IBM
    before the PC revolution, the UK steel industry,
    the telecoms market, Xerox, Dunlop, Woolworths,
    etc
  • All profits are transitory. See slides above on
    this
  • Same idea re barriers this time. Barriers to
    entry not what they were. Many towns had only
    one or two booksellers, banks, record stores.
    And along comes Amazon and co and jumps the
    barriers.

54
The cherry picker strategy
  • Entrants need not, and generally do not, take on
    the dominant incumbent directly, ie do not seek
    to replicate the dominant firms business model.
  • There is the possibility of the cherry picking
    strategy, where entrants seek to identify
    particular segments of the market where they
    might prosper. Where perhaps entrepreneurial
    alertness/ flexibility overcomes the advantages
    of size.
  • For example when postal services have been
    liberalised new entrants are often accused of
    cherry picking, ie focusing on the most
    attractive bits of the market like big cities, or
    business mail, or parcel services.
  • And think how the bottled water market has
    developed.

55
Consider re barriers
  • The question of harmfulness. If mon is harmful
    by implication so are the barriers protecting it.
  • But can all so-called barriers really be
    harmful?
  • For example a standard barrier identified in
    all the textbooks is the absolute cost barrier.
    These are said to arise from first-mover
    advantages based on scale or the aggressive
    chase down the learning/ experience curve or
    reputation etc.
  • But why is this harmful? What is meant? Can
    there be competition without aggression, without
    someone trying to be a winner?

56
  • This situation described could be seen as the
    natural result of one business taking the risks
    (making commitments) involved in developing a new
    product and moving first to develop the market.
    The reward is possibly an early cost advantage
    but remember in fact not all first movers become
    long term winners (Apple!). So could the
    advantage be seen as a reward for the socially
    useful risk of pioneering.
  • Also network effects (see next slide), create
    barriers which protect some companies but this
    seems to result from consumer choice. This might
    be tough luck on the competition but is it
    harmful?

57
Network effects
  • A factor encouraging dominance but deriving from
    the demand side. Idea is that for some products/
    services, the value of ownership/use increases
    the more owners/users there are. Because of the
    benefits of the growing network (installed base)
    of users.
  • For most products this doesnt apply. VW cars
    dont become more valuable to you as more people
    acquire them. Au contraire.
  • But for some things it does. Software for
    example. Microsoft arguably owes is success to
    this effect. Consumers value compatibility/
    transferability and so we have all tended to
    adopt the same OS and related software. Could
    have been Apple, or IBM. A dominant supplier was
    likely to emerge here.

58
Strategic barriers?
  • However deliberately created strategic barriers
    may be more problematic.
  • Product differentiation, advertising and brand
    names, product proliferation, predatory pricing
    are seen by some as deliberate strategic
    actions aimed at protecting a business from
    entrants. But is this always the case?
  • Take advertising. Admittedly some may indeed be
    strategic. But adv can also be socially
    valuable because consumers value information
    about product specs, qualities, options. How else
    can we learn about whats available? Or product
    proliferation in cereals/ toiletries etc which
    could be seen as improving consumer choice.

59
Two ways of seeing
  • It seems there are (at least) two ways of seeing
    firm behaviour. One looks at it as largely about
    on going competitive efforts to get and stay
    ahead, a treadmill, the other sees most firm
    actions as attempts to destroy competition with
    negative social effects. Thus even if a monopoly
    has low prices because it is worried about the
    threat of entry etc it can be attacked for
    predatory behaviour (as Microsoft has been).
  • Maybe the competitive process is inherently
    double edged. Some see a half filled glass,
    others a half empty glass.

60
4. Profit maximisation
  • Mon model assumes p max. Extreme? Possibly,
    think back to the possibility that for various
    reasons some firms pursue objectives other than
    profit such as size/ and growth (Marris).
  • If so, this would lead away from the harmful
    outcome nearer to the competitive outcomes for
    price/ output.
  • Eg the Baumol (profit constrained sales
    maximisation) model (see George) must lead to
    lower prices and higher output.

61
5. No price discrimination
  • Standard model assumes there is no price disc by
    the monopolist.
  • First, consider the principle of p
    discrimination. Charging individual consumers
    (or groups of consumers) different prices
    according to their maximum willingness to pay
    for the product.
  • In the standard monopoly model (see fig) the
    initial monopoly profit rectangle is captured
    or appropriated consumer surplus. But this
    leaves a lot of consumer surplus unexploited.
    Price disc is an attempt to exploit it more
    fully.

62
Diagram 4 Price discrimination Explanation in
lecture
P
Q
63
Degrees of price disc
  • 1st degree where you seek to extract/
    appropriate the whole of the available consumer
    surplus
  • 2nd degree where consumers pay a different price
    according to the quantity they choose to buy
    (quantity discounts, multi packs)
  • 3rd degree customers are segmented by type (age/
    sex/location/) and charged according to the
    segments willingness to pay.
  • See a good text such as George/ Church et al for
    details of these and examples

64
The paradox of price disc
  • If a monopolist can achieve p disc a potentially
    paradoxical result arises. The social harm of
    monopoly falls. Paradox because a price disc mon
    is more powerful than before but less harmful.
  • Why? Because it gets nearer to the desired
    allocative efficiency (ie competitive) output!
  • Of course the distribution of income outcome
    might not be acceptable but that is not an
    efficiency issue, it is an ethical/ political
    one, an issue of judgement which economists are
    no better at deciding than plumbers or dentists.

65
However re price disc
  • We have to note that whilst all mons would seek
    to use p disc it is not always possible to do it
    in practice. And it is not a costless exercise.
    There fore not all will actually be observed
    doing it.
  • Difficult? first because of information problems
    (about consumer willingness to pay) and second
    because of arbitrage problems (clever
    entrepreneurs).
  • So should competition policy encourage it or
    discourage it?

66
6. Cost differentials
  • The standard mon model assumes that the mon and
    the comp industry have the same level of costs.
    No economies of scale exist. The LRAC curve is
    flat.
  • But this is strange. Because a major reason for
    mon will be economies of scale (and scope)
    benefiting large-scale operations (car assembly
    or supermarkets say), so the mon generally will
    have lower costs. So is the standard comparison
    fair?

67
Maybe not
  • Oliver Williamson looked at the standard model,
    and drew in a lower cost line to allow for scale
    benefits (a declining long run average costs in
    the textbook language).
  • Consider as he did what would happen to prices
    now, and the deadweight loss of monopoly.
  • He used some simple arithmetic concerning demand
    and cost parameters to suggest the following
    conclusion.
  • Relatively small cost reductions from beneficial
    scale effects (say 10) would outweigh allocative
    losses due to full market power pricing
  • If scale effects are large there may even be net
    gains from monopoly rather than Harberger type
    losses.

68
Williamsons diagram
  • D 5 in the lecture

69
On the other hand
  • Remember organisational or x efficiency? If m
    power creates opportunities to slacken off, costs
    may creep upwards. And so offset some of this
    good cost result.
  • See this by doing the W diag again but factoring
    in rising costs due to cost creep. If these
    outweigh the benefits of scale then you are back
    to the original Harberger loss or worse.
  • However note that all is not lost! The
    slackers get utility from slacking/ big offices
    etc and this is in a way a redistribution of
    total market surplus not a total (or deadweight)
    loss.

70
X-tensions
  • What if the rise in costs affects Fixed Costs but
    not Marginal Costs? That is inefficiency strikes
    at overheads and the like, not at incremental
    production costs. A plausible scenario.
  • Then the equilibrium price/ output doesnt
    actually change, and the cost increase is pure
    transfer (from owners to employees). The social
    loss of monopoly isnt increased.

71
An x efficiency conundrum
  • Under highly comp conditions would employees/
    managers of all firms really feel threatened by
    the loss of employment and work at peak levels?
  • If there is full emp in the competitive economy
    then the loss of job isnt much of a threat!
    Redundant resources get picked up elsewhere! So
    will there really be universal x efficiency in
    the competitive economy? Good question.
  • Plus highly comp markets can be harsh and un
    compromising and breed social resentment and
    defensive reactions etc (read all about it in
    Zola, Dickens, Dos Passos et al), and so damage
    social efficiency! What is the anti globalisation
    movement on about? Is efficiency produced by
    implied threat necessarily desirable?

72
7. The Coase critique
  • Ronald Coase argued that the standard m model
    makes no allowance for the role of product
    durability (use over multiple periods). Some
    products are bought for immediate consumption but
    many are not (houses for ex)
  • The mon in general faces a credibility problem in
    getting the mon price to stick. It has in a way
    an incentive to cheat on its own monopoly price.
    Because once it successfully sells the m quantity
    at the m price, it could in principle earn even
    more by then undercutting this previous price.
  • This is not a problem in a single period textbook
    model, cause then there is no next period in
    which to cheat yourself! But what if we consider
    the problem over time, with multiple discrete
    selling periods?

73
Coase cont.
  • With a multi-period setting product durability
    becomes an issue. Why?
  • Because in the first period the m sells the m
    quantity to those with the highest willingness to
    pay for those units of output.
  • But these folk still have the product in the next
    period (or sell it second hand if they lose
    interest), and those still in the market by
    definition will only buy at a lower price. So
    the m will need to lower prices (cheat itself) in
    period two.
  • BUT

74
Coase cont.
  • If the m is likely to cut prices in the second
    period who would buy in the first period when
    they can hang on a bit for a bargain? Will some/
    a lot of people not postpone buying? Would we
    not be influenced by the possibility of falling
    prices to wait? Of course it would depend on how
    impatient consumers were. Or technically, by
    how much we discount the future.
  • Some people do time purchases of consumer
    durables (autos, PCs, TVs) quite carefully (we
    wait for Christmas sales for example!)

75
Coase concluded
  • That the need to lower prices over time
    (inter-temporal price discrimination if you like)
    would reduce m pricing power. Reduce the m
    ability to capture m profits. Depending on how
    long a period is. A day, a week, a year. And of
    course on consumer patience.
  • So a mon in this situation can only seek to
    ensure max profits now if it can commit itself to
    not cutting prices later. Or if it leases rather
    than sells its products outright (as Xerox, IBM,
    et al used to do). See if you can figure out why.

76
Pacman defence
  • However as you will expect there is a counter
    argument. Durability might work to the advantage
    of the m instead!
  • The idea is now that the m acts tough and tells
    consumers it will set the max price it can get
    for each unit (say houses) and wait until it gets
    a taker. Then it will set a slightly lower price
    and wait until that unit sells and so on. So it
    becomes a battle of wills, and if the m wins it
    extracts lots of lovely consumer surplus.
  • Could this work? Depends on things such as how
    long the m can credibly afford to hold rather
    than sell its products. And consumer patience.
    Think of this the next time you by a new CD or a
    DVD.
  • Pacman implies a strategy of turning the
    tables on an opponent. Eg an intended takeover
    target suddenly makes a bid for a putative
    acquirer instead.

77
8. Countervailing power
  • Standard m model assumes no countervailing power
    on the other side of the market. ie buyers are
    numerous and dispersed and cant argue back.
    Coalition problems.
  • But what if they are not? What if the buyers are
    few, or even only one (a monopsonist). It
    happens. Supermarkets like Wal Mart and Tesco
    can take on even powerful suppliers like Heinz,
    Coca Cola, or LOreal.

78
  • In this case the monopolists profits will be
    reduced because it now faces more powerful buyers
    who can bargain rather than take it or leave
    it.
  • The mon seller still wants to set the m price,
    but the buyers demand a lower price (which max
    their profits) because it or they have monopsony
    power (buying power)
  • Now in fact there is no easy predictable (ie
    equilibrium) outcome because it will depend on
    relative bargaining power and credibility. The m
    wants to set the high m price, the buyers demand
    the low monopsony price (see textbook on how
    difficult it becomes to find the outcome now)
  • This redistributes potential mon profit (consumer
    surplus) back to the buyer side.

79
Balance of power?
  • Switching costs. If the buyer becomes familiar
    with particular suppliers this may raise costs in
    switching to another.
  • Information costs. Often consumers find it
    expensive to be properly informed. Car servicing,
    medicines, financial services, software. Power is
    with the best informed.
  • Economics of DIY. If the customer could DIY this
    constrains suppliers. If suppliers could
    integrate forward it constrains buyers.
  • Reputation. Being a Toyota supplier is a big
    deal, powerful suppliers prepared to pay for
    that. Buying Intel chips is a safe bet, customers
    like Dell and Compaq pay for that. Airlines will
    only use a big name engine supplier like RR.
    Harvard is the place for an MBA. Msoft for
    software writers.
  • The customers customer. When your customer
    sells on you might be able to influence its
    customers. Does Dell install Microsoft/ use
    Intel because it likes them best or because it
    matters to customers who will pay a premium for
    these things?

80
Another paradox
  • Arises in this situation.
  • It can be shown (bilateral monopoly case) that
    vertical integration between two monopolies (one
    buying what the other sells, say a generator and
    a distributor of electricity) can produce social
    benefits. Such as from reducing bargaining
    costs.
  • Paradox here being that two mons are therefore
    better than one.

81
9. Mon and innovation
  • Does mon power really harm innovation (dynamic
    effic) as Arrows famous model suggests?
  • Recall first that this concerns the strength of
    the incentive to innovate, ie it is about
    relative desire to use or adopt a new idea (but
    not to look for it in the first place!) It is
    intuitively appealing, but still might be
    wrong-headed. Plus.
  • It says nothing about relative ability to
    innovate! Which may well be more important in
    practice.
  • Maybe why George text says the model strains
    credulity. Lets investigate a bit further.

82
Comp for the market v comp in the market
  • An important distinction to keep in mind.
  • What is the key issue in RD/ innovation?
  • Is it driven by competition already in a market,
    or by competition for a market (which may not
    even exist yet)?
  • Point? There may be a lack of competition IN a
    particular market (telecoms 20 years ago) but
    that doesnt stop competition FOR that market by
    others investing in RD.
  • In pharmaceuticals patent protection often
    diminishes competition in the market for a decade
    or so, but it cannot prevent competition FOR the
    market continuing. Other firms can (and do) keep
    investing in RD and if one comes up with
    something better, can then compete in the market
    or itself become the dominant supplier.

83
  • If we look at competition in innovative
    industries we often see this. Several businesses
    or entrepreneurs seek new products/ technologies.
    Winning is nice for the winner, but not a
    guarantee of sustainable dominance. The race can
    continue. Successful innovators can seek to
    replace the incumbent.
  • Remember the words of Intel man, only the
    paranoid survive. Meaning no matter how
    dominant you are today you can disappear
    tomorrow.
  • So should we worry a lot about the state of
    competition in a particular market if there can
    be competition for it?

84
Value innovators
  • Innovators focus on creating new markets, not on
    beating up on the competition. Successful
    companies do not focus on the competition but on
    making competitors irrelevant by providing buyers
    with a quantum leap in value.
  • Value innovators use the consumer as the
    reference point not the competition. Innovation
    is driven not by the technology but by customer
    value. VI ask are we offering consumers
    radically superior value? Are our prices
    accessible to the mass of buyers in the market?
  • Examples Wal Mart, Ikea, CNN, SAP, Starbucks.
  • Emphasis of these companies is not on patenting
    ideas but on the combination and arrangement of
    elements (bundles) attractive to consumers. And
    hard for competitors to match. Harvard BR, 2000,
    Sloan MR 1999

85
Some characteristics of investment in RD
  • 1. It is very expensive and time consuming
    needing specialised resources and facilities.
    Think of pharmaceuticals or electronics.
  • 2. It is very risky there is a lot of
    uncertainty involved, will you find something,
    will it sell, will you recover dev costs?
  • 3. Costs involved are open ended (once you start
    its hard to stop!) and largely sunk.
  • 3. Investment is hard to evaluate, (what is the
    NPV?) so raising finance is a problem. The
    bankers find it hard to fathom.
  • 4. The output is knowledge, which is hard to
    protect, so hard to capture all the rewards if
    successful. Some, or a lot, will leak out.
    Despite patents. You might do the work whilst
    others reap the rewards.
  • 5. It is difficult/ and so costly to organise
    and manage effectively within the organisation
    (monitoring and controlling the process)
  • 6. There may be significant economies of scale/
    scope involved.

86
Developing drugs
  • Almost half of the profits of major drug
    businesses such as GSKB (until recently this was
    four different firms) go into development (2
    billion)! Indeed this has been the driving force
    in the recent development of such giants. To
    ensure a blockbuster every now and again a
    company has to bring some new products to the
    market every year. Only a very big business can
    achieve this.
  • You must have a solid portfolio of new drugs in
    the RD pipeline many of which are unlikely to
    make it. Average RD lead time is 12 years and
    costs 200m. The minimum annual spend to stay in
    the race is put at around 2 billion!
  • Sources Deutsche Bank/ Lazard Freres.

87
Markets and RD/ innovation
  • What is likely to promote the best level of
    investment in RD socially speaking?
  • Note immediately that competitive markets driven
    by the profit motive cant produce the social
    optimal level anyway (where msc msb), so it is
    about the choice between two structures (mon and
    comp) which are both imperfect. Why? Because
  • The social benefit of RD exceeds the private (eg
    because of spillovers), and the social costs of
    RD is less than the private (eg because of
    taxes). So society will favour more RD than comp
    markets will promote.

88
RD competition
  • First, it is possible that too much competition
    in searching FOR the next big winner could be
    wasteful cause it might lead to excessive
    spending (a la Posner). A lottery type effect
    (see earlier slide on this). The thought of a
    big prize can cause us to behave foolishly. The
    total amount spent approaches or possibly exceeds
    the prize to be won. Could competitive firms end
    up doing the same thing looking for winners?
    Drug companies for example. Would that be
    socially useful?

89
  • Second, possibly too much competition will reduce
    RD because it reduces the ability to finance
    risky investments. Capital suppliers find it
    hard to figure the probabilities. And find it
    hard to monitor effort/ performance. Thus, RD
    is in practice largely financed from business
    profits. But highly competitive markets dont
    allow for above normal profits. So how can firms
    finance RD? Some economists have argued that
    for this reason market power will encourage
    innovation rather than harm it.

90
  • Third, too much competition may reduce RD
    efforts and innovation because of problems with
    appropriability of rewards. Even if you succeed
    how can you stop fast imitators? Look at Sony!
    At how quickly its innovations are copied. It
    has to run very fast to stay ahead. Will it get
    fed up? Monopolist presumably has less to worry
    about here so stronger incentives to spend.

91
  • Fourth mon incentive to innovate may be stronger
    than Arrow allowed for because in practice it
    knows that if it doesnt innovate its current
    profits can eventually be eroded by an innovating
    entrant. This is RD as a protection policy. If
    the monopoly thinks forward it must see this. In
    fact it can be shown in principle that a
    monopolist has a greater incentive to innovate to
    sustain itself than a potential entrant has to
    innovate and then compete with the monopolist.
  • Hence again the man who ran Intel, a firm with a
    lot of m power only the paranoid survive. Or
    the boss of GE who urged his executives to
    destroy the business before someone else did.

92
  • Fifth, a monopolist may even over invest in RD
    simply because it can afford to. It has the money
    to indulge itself and to make sure it stays ahead
    of the game. Managers especially may be prone to
    this because they gamble with someone elses
    money. The shareholders bear the risks of
    failure, managers get the glory for success.
    Managers can lose a career to a successful
    entrant, shareholders just lose money.

93
  • Sixth, innovation might be best served by a
    moderate degree of competition amongst strong
    rivals rather than intense comp. Oligopolists as
    we see below soon learn that price competition is
    destructive all round and will try to cooperate.
    This possibly has the effect of deflecting
    competitive efforts to the less destructive
    innovation (or advertising) where firms can get
    an edge which is more difficult for others to
    quickly follow up.

94
  • Finally, too much competition might harm the
    realisation of significant economies of
    scalescope in RD process
  • Scale as we have seen is likely to be vital when
    development costs are big. Dev costs are paid
    upfront and have to be amortised over future
    output. The bigger the better, because of the
    pricing implications of cost recovery. Small
    comp firms just couldnt do it. (what about
    collaboration to overcome this disadvantage?)
  • And scope? Portfolio effects exist. Pursuing
    just one idea is very risky! But having a
    portfolio of ideas on the go means things might
    balance out. Some you win many you lose. But a
    big winner compensates for all the losers. Like
    a share portfolio, the winners compensate for the
    duds. This makes money easier to raise in
    principle. (Although note, a financier could in
    theory invest in a portfolio of small business
    RD).

95
The Schumpeter hypothesis
  • A combination of some of the above arguments was
    in fact first put forward in the 1940s by Joseph
    Schumpeter and much of the subsequent debate in
    the area has referred back to his ideas (and of
    course Arrows).
  • These were to the effect that technological
    dynamism was in fact best served by big business
    with a good degree of market power (not
    necessarily monopoly however). As we will
    discuss later these views have been the subject
    of much empirical research and testing.

96
10. View of competitive process
  • Finally, The mainstream textbook view of
    competition and the comp process is arguably very
    narrow. PC MC models basically, with even the
    latter tagged harmful. But is that it really?
  • There are other ways of looking at the world.
    Broader, more dynamic, more realistic,
    overlapping views of competitive process.

97
The Austrian view of competition
  • According to this school of thought the textbook
    focus on industry structure is misguided. It
    is the FIRM alone that matters, because
    industry structure is a consequence of how
    firms compete not vice versa
  • Market structure is an outcome of competition
    between firms, the search for competitive
    advantage, not a determinant. It is endogenous
    not exogenous. Firm actions and relative success
    determines both market structure and average
    profitability. The idea that market structure
    drives profits is thus spurious. Back to this
    later under evidence. Firms are unique
    heterogeneous. And everyone is competing with
    everyone else for resources/customers.
  • See for ex Hill/Deedes, J of Management Studies,
    1996

98
Interdependence
  • The two views are of course not mutually
    exclusive. Firm actions can obviously affect
    market structure outcomes, and market structures
    can influence firm actions. There is
    interdependence between the two rather than the
    one way causation of the textbook S-C-P model.
    This seems likely.

99
John Kays case for competition
  • Is much better than standard textbook case.
  • In The truth about markets (2002) book Kay
    argues that the case is really about how
    competition encourages the variety of experiments
    or plurality of approaches and is ultimately more
    responsive to consumer needs. Monos finds it
    hard to promote plurality of thinking and are
    less responsive to needs. See esp his chap 30 on
    disciplined pluralism. Policy should promote
    pluralism not some idealised state of
    competition. Pluralism is about encouraging and
    making use of new info to innovate in value. So
    if one firm earns excess profits it is not a
    matter of concern as long as others are at least
    allowed to seek to challenge it.

100
Competition is a process
  • Competition is a process (not an event) arising
    from the on-going desire of organisations to
    search for ways of creating and capturing value.
  • Whenever one business identifies and exploits a
    profitable opportunity it demonstrates its
    potential to others who seek ways of grabbing a
    piece of the action.
  • PCs, memory chips, selling on the internet,
    mobile phones, budget airlines, .

101
The nature of competition
  • Firms compete in different ways, or different
    combinations of ways, which change over time.
  • Price competition
  • Marketing/ advertising/ differentiation
  • Product development/ quality improvements
  • Product range (esp retailing)
  • Reputation
  • Innovation
  • Litigation

102
Creating competitive advantage
  • Cheaper (lower costs) producer ?
  • Better (superior perceived quality) ?
  • Newer (more innovative/up to date/fashionable) ?
  • Faster (speed to market) ?
  • More desirable/ distinctive (successful
    branding)?
  • Better reputation ?
  • First mover ?
  • Provide your own examples of firms that compete
    successfully on this basis.

103
Competition processes
  • Imitation/ replication good ideas, products,
    services get copied/ imitated rapidly(often even
    patents arent much of a protection), eg Amazon,
    Easy Jet.
  • Commodification once innovative products
    eventually tend towards standardised commodities,
    eg microprocessors, most pharmaceuticals, ball
    point pens.
  • New entry first mover profits are dissipated by
    attackers, new entrants, eg photo-copiers, mobile
    phones, ..And NB new entrants need not be new
    businesses.
  • Technological change competition can appear from
    unexpected directions. On-line degrees, internet
    bookshops/ banks, e mail, .
  • Fragmentation specialist firms begin to cherry
    pick the most valuable segments postal services,
    consumer electronics, boutique hotels.

104
Processes cont.
  • Deregulation/ liberalisation established
    monopolistic positions (often granted by state
    fiat) are opened up, eg airlines, water, postal
    services, electricity, telecoms.
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