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.