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Industrial Economics A: Structure, Conduct and Performance Lecture 1

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Module logistics See the module outline for details. Some highlights: Textbooks: Lipczynski, Wilson and Goddard Church Assessment: 1.5 hour exam (70%), and an individual coursework (30%) The seminar will take place during teaching weeks 9 and 10 (depending on your group).

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Module structure

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What is industrial organization? IO is the application of microeconomic theory to the analysis of firms, markets and industries In IO (unlike microeconomics), the industry structure is entirely modelled and is dynamic. Number and size distribution of firms Barriers to entry Product differentiation Vertical integration and diversification

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What is industrial organization? IO increases our understanding of problems faced by firms: Externally, how firms compete in the marketplace (Theory of markets) Firm as a black box and focus on how firms compete with each other. Internally, organizing production within the firm (Theory of the firm) Look inside the firm and explain things firm size, the boundaries of the firm, and incentives within the firm.

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IO and policymaking For policy makers: Competition policy aims to prevent firms from abusing market power. [Sherman Act 1890, China antitrust law 2007] How to measure market power and excess profit? How competitive is a specific industry? What types of firm behavior can make an industry less competitive? What type of market structure is most conductive of innovation?

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IO and policymaking: The Google antitrust case 2010: The EU commission accuses Google of promoting its shopping service in internet search at the expense of rival services Google is accused of systematically favouring its own comparison shopping product in its general search results pages Google’s response: “Economic data (…), and statements from complainants all confirm that product search is robustly competitive”. Google claims that Google shopping is operating in a field that includes Amazon and eBay, where shoppers go to compare prices.

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IO and policymaking: The Google antitrust case Google could face a 3bn euros fine. Related to that case, IO provides answers to the following questions. How to define a market? How to measure market power? How to stop dominant firms from abusing market power?

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Typology of market structures

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Austrian School: Schumpeter Dynamic theory where markets are changing due to the activities of entrepreneurial and profit-seeking innovators. “Creative destruction” (Schumpeter, 1928): Competition is driven by innovation Innovation destroys old products and processes and replaces them with new ones. Innovators earn profits and imitation gradually erodes these profits by cutting prices and raising input costs. Abnormal profits and market power are necessary to motivate firms to innovate, and improve products in the long run

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Creative destruction: The music industry

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The Chicago School The Chicago School (1970-80s): Also argues against government intervention Large firms are large because they are more efficient In the long run abuse of market power is unlikely, e.g. collusive agreements are unstable Markets have a tendency to revert towards competition, without the need for government intervention

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The SCP paradigm Concentrates on empirical analysis rather than on theoretical analysis. Bain (1956): There is a causal relationship between concentration and profitability:

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The SCP paradigm Structure  Conduct  Performance

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The SCP paradigm According to SCP, relationships between structural variables and market performance hold across industries. The line of causality is from structure through performance. If a stable relationship is established between structure and market power, it is assumed that structure determines market power.

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SCP & European banking: Structure 1980s: European banking was fragmented. Banks did not operate in other countries [high entry barriers]. Domestic banks did not face competition from foreign banks. Deregulation made EU banking more competitive Second Banking Directive, 1990 Creation of the euro As a consequence: Banks able to trade throughout Europe. Lowered entry barriers. Do this make the industry more competitive or less competitive?

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SCP & European banking: Structure 1990-2009: decline in the number of banks

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SCP & European banking: Structure 1990-2009: increased level of seller concentration

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SCP & European banking: Conduct Following the deregulation, many banks have consolidated (M&A), e.g. Unicredito (Italy) and HVB (Germany) BNP Paribas (France) Banco Nazionale de Lavoro (Italy) Banco Santander (Spain) and Alliance of Leicester (UK) Large banks have adapted their structures, risk management and strategic planning functions to deal with pan-European activity.

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SCP & European banking: Performance 1990-2006: increased profitability despite the lowering of entry barriers. How to explain the increased profits? Increased consolidation; Product diversification; Cost-cutting

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SCP: Reverse causality? Structure  Conduct  Performance Conduct to structure? R&D, advertising, differentiation Performance to structure? Growth and changing market shares Performance to conduct? Profitability and capacity to invest in R&D, or cut prices

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Competition policy and SCP Structure  Conduct  Performance Public policies that aim to prevent the abuse of market power Preventing mergers beyond a certain scale [STRUCTURE] Price controls, restrictions on collusion [CONDUCT] Policies that also affect firms’ PERFORMANCE

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Profits in America and the practical relevance of IO Source: ‘Too much of a good thing’. The Economist, 2016. Profits have risen in most rich countries over the past ten years. E.g. America Airlines: Used to make losses; but made $24bn profit in 2015. How? The falling price of fuel has not been passed on to the consumers. Why not? Consolidations has left the industry with 4 dominant firms with many shareholders in common.

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Profits in America

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Profits in America - Historical developments In the 1990s American firms faced a wave of competition from low-cost competitors abroad. In 1998, Joel Klein (DoJ), declared that “our economy is more competitive today than it has been in a long, long time.” How to explain the recent increase in corporate earnings? Since 2008 American firms have engaged in mergers worth $10 trillion, allowing the merged companies to increase market shares and cut costs. Two-thirds of the industry sectors became more concentrated between 1997 and 2012. The average share of the top 4 firms has risen from 26% to 32%.

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Profits in America

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Profits in America

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Profits in America About 25% of America’s abnormal profits are spread across a wide range of sectors. Another 25% comes from the health-care industry (pharmaceutical and medical-equipment). Patent rules allow temporary monopolies on new drugs and inventions. Much of health-care purchasing is controlled by insurance firms. Four of the largest, Anthem, Cigna, Aetna and Humana, are planning to merge into two larger firms. The remaining 50% abnormal profits are in the technology sector, where firms such as Google and Facebook enjoy market shares of 40% or more.

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Production and costs

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Production and costs Long run production function: Short run production function, K fixed, and assuming L is variable in the short run: In some cases, L can also be fixed in the short run.

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Short run production

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Short run costs

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Long run costs In the long-run, firms can change their usage of all the inputs, including capital, number and size of factories etc. LRAC: Lowest cost of producing any given output level when the firm can vary both K and L. Draw SRAC for all possible levels of K. The curve that enfolds these curves from below is the LRAC. Compared to SRAC, LRAC decline longer before finally increasing LRMC: long-run marginal cost

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Long run costs

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Application to oil pipelines Costs associated with construction and operation: Planning and design Acquisition of clearing the right-of-way Construction costs Steel for the pipeline Pumps (One time fixed costs) Electricity to power the pumps (variable costs) Labor (monitoring personnel) (fixed cost)

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Application to oil pipelines Electricity costs vary with throughput, but the number of personnel does not. The salary of personnel is avoidable if the pipeline shuts down. What are the variable costs? What are the fixed costs?

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Economies of scale Economies of scale impact the LRAC Minimum efficient scale = output level beyond which firms can make no further savings in LRAC through further expansion.

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Economies of scale

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Empirical studies of economies of scale Some firms have U-shaped LRAC However, manufacturing firms often have L-shaped LRAC Estimates of MES:

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Empirical studies of economies of scale Survivorship studies: If a particular plant size is efficient, eventually all plants in that industry should approach that size. Example from the beer industry:

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Economies of scope Economies of scope are the cost savings that arise when a firm produces two or more outputs using the same set of resources. Example 1: Manufacturing process Oil refineries produce gasoline and kerosene as part of the refining process Example 2: Knowledge gained from developing, producing, or marketing one product can be applied to another product R&D investment for a specific software can benefit other categories of softwares

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Economies of scope Example 3: Umbrella advertising Advertising one Samsung product will lead to more demand for other Samsung products (even if they are not related). New products are easier to introduce when there is an established brand with the desired image. Virgin: 400+ companies, active in railways, airlines, soda, mobile, media etc.

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Demand elasticity Price elasticity of demand: Note that PED

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Demand elasticity Marginal revenue: If , MR>0. When the demand is elastic, MR>0 If , MR

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Demand elasticity

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Demand elasticity

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Cross-price elasticity of demand CES>0. Goods 1 and 2 are substitute. As the price of Good 2 increases, consumers switch from Good 2 to Good 1. CES

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Summary IO views industries as dynamic entities Practical relevance of IO (competition policy; high levels of concentration) Theoretical IO: Austrian school, Chicago school… SCP: empirical approach; conceptual limitations Review of production and costs concepts