lecture 1 handout

Lecture 1Introduction

L12418 Industrial Economics

Dr Matthias Dahm

January 2014University of Nottingham

School of Economics

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Lecturer: Dr Matthias Dahm

Office hour in SCGB B47: email for appointment(but most weeks Wednesdays 11-12 a.m.)

Teaching methods

18 Lectures

Tue. 11 a.m. (LASS-B63) & Wed. 10 a.m. (LIFESCI B3)

slides: will be available on Moodle before lecture

3 Tutorials: weeks 23, 25 and 27 - sign up via Moodle

Alex Possajennikov teaches some tutorials

aim is to deepen understanding of material via exercises

aim is to make students think – some exercises are challenging

students are expected to prepare answers before the tutorials

tutorial sheets/solutions: will be available on Moodle

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Method of assessment: 2 hour written exam (100%)

answer two questions (one compulsory, one out of three)

previous examination papers and feedback for all modules canbe viewed online in Moodle

feedback exercises toward the end of the module

Marking criteria

questions have analytical & theoretical part

answers should be rigorous and show modeling skills

requires to work through the exercises

answers should show perspective on module content

requires to do the reading assignments

Pre-requisite: L12302 Microeconomic Theory

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L12418 Industrial EconomicsModule Texts

PRN Pepall, L., Richards, D. & Norman, G. (2010).Contemporary Industrial Organization: a quantitativeapproach. Wiley.

LWG Lipczynski, J., Wilson, J.O.S. & Goddard, J. (2013).Industrial Organization: competition, strategy, policy.4th edition. Pearson.

M Martin, S. (2010). Industrial Organization inContext. Oxford University Press.

CW Church, J.R. & Ware, R. (2000) Industrial Organization: A StrategicApproach. McGraw-Hill.Available at: http://works.bepress.com/jeffrey_church/23

CP Carlton, D.W. & Perloff, J.M. (2005). Modern IndustrialOrganization. 4th edition. Pearson Addison-Wesley.

C Cabral, L.M.B. (2000). Introduction to Industrial Organization. MITPress.

BP Belleflamme, P. & Peitz, M. (2009). Industrial Organization.Cambridge University Press.

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http://works.bepress.com/jeffrey_church/23

L12418 Industrial EconomicsAim of Module

Comprehensive and coherent overview of Industrial Economics

Empirical and theoretical approaches (but emphasis on latter)

Topics may include:

Market StructuresFrom Perfect competition to Monopoly via Oligopoly, includingProduct Differentiation

Strategies and Conduct of FirmsCollusion; Price discrimination; Entry deterrence; Verticalrelationships; Advertising; Research & Development

Regulation of IndustriesRegulation of monopolies; Antitrust laws; Public policy

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What is Industrial Economics?

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What is Industrial Economics?BBC on 16 January 2014 “Labour to force bank break-ups”

Labour officials say:

“. . . Britain has one of the most concentrated banking systemsin the world, with just four banks controlling 85% of smallbusiness lending. . . excessive market power of banks”

“. . . break up of the UK’s largest retail banks. . . ”

“. . . create two new large banks to challenge the existing bigbanks. . . ”

“. . . expect the new challenger banks to each have at least 6%of the personal current account market. . . ”

“. . . A new maximum threshold for market shares which wouldtrigger future CMA investigations if banks grow above thatsize. . . ”

“. . . and an automatic ban on any takeover that created abank bigger than the threshold.”. . . ”

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Bankers say:

“. . . this would lead to what they call a perverse outcome. . . asthey approached the maximum size they would dumpcustomers they deemed low quality or loss-making. . . ”

The governor of the Bank of England, Mark Carney says:

“. . . just breaking up an institution doesn’t necessarily create amore intensive competitive structure... It’s not just about oneaspect. You need to look at the entire business model and riskprofile.”

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Key questions:

What is the relationship between market structure andeconomic performance?

If we observe that there are only a few large banks, can weconclude that they have excessive market power?

LWG p. 18: Case study on market structure and performance inEuropean banking.

PRN p.14:

“The reason we study industrial organization is tounderstand market competition in all its dimensions andto develop appropriate public policy when the marketimperfections in that competitions yield unsatisfactoryoutcomes.”

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What is Industrial Economics?

Industrial Economics is a synonym for Industrial Organization

The study of real world markets:

market for operating systems

computer ship market

soft drink market

. . .

These are not markets with numerous small firms

The perfectly competitive model does not apply

Industrial Economics is the study of imperfect competition

Industrial Economics provides the basis for regulation andcompetition policy

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How do we study Industrial Economics?Who won last year’s Nobel Prize in Economics?

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How do we study Industrial Economics?Jean Tirole’s approach (Royal Swedish Academy of Sciences)

“He has created a unified framework for IO theory andregulation, founded on a rigorous analysis of strategicbehavior and information economics”

“By deploying a consistent conceptual framework over a widerange of issues, he became a leader in the creation of the firstencompassing and coherent theory of IO”

“his rigorous thinking has overturned previous conventionalwisdom”

“Tirole has shown how the justifications for publicintervention frequently boil down to problems of informationasymmetries and credible commitments. These general lessons- together with a catalogue of specific applications - form arobust foundation for policy analysis”

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How do we study Industrial Economics?

Formal mathematical modeling allows

careful thinking about complex world

to see how each assumption influences the outcome

to derive testable predictions

Game theory allows

analysing strategic interaction between firms

when decisions are interdependent

Tool kit contains different models, as markets are different:

a few large firms or one large and several small firms

differentiated products or identical ones

price competition or non price competition (like advertising)

. . .

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“Traditional Industrial Organization”

The field of industrial economics emerged:

Context of antitrust policy in U.S.

Tried to give guidelines to competition policy

Aimed to make coherent argument to guide legal decisions

E.g. did U.S. Steel abuse monopoly power (1920)?

Can one infer illegal behaviour from firm size or structure?

“Traditional Industrial Organization” was based on thestructure-conduct-performance paradigm

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The structure-conduct-performance paradigm

Seminal early contributions (after 1930):

Identify links between market structure and market outcomes

Obtain data on prices, profits and market structure

Identify statistical relationships between structure andperformance

Basic principle:

There is a spectrum of market structures

At opposite ends are monopoly and perfect competition

All markets lie along this spectrum

Determine from observable evidence whether industry inquestion is closer to monopoly or perfect competition

Provide road map for policy, like by how much raises a bitmore concentration prices above costs?

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Lipczynski, Wilson and Goddard, Industrial Organization PowerPoints on the Web, 4th edition © Pearson Education Limited 2013

Slide 1.2

Figure 1.1 The structure–conduct–performance paradigm

LWG, Figure 1.1

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Lipczynski, Wilson and Goddard, Industrial Organization PowerPoints on the Web, 4th edition © Pearson Education Limited 2013

Slide 1.2

Figure 1.1 The structure–conduct–performance paradigmLWG, Figure 1.1

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Main criticisms of the SCP paradigm

1) Empirical findings can be interpreted in different ways.

SCP researchers produced vast amount of empirical findingslike firms with large market shares tend to earn greater profit.

SCP researchers: collusion hypothesisthe higher market share, the greater monopoly power, thehigher profit

Chicago school: efficiency hypothesisSome firms have superior technology and talent (are moreefficient, as costs lower) and have thus both larger size andhigher profits

Implies: punishing largest firms means punishing success

Cournot model in which costs differ across firms supportslatter view

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2) Strategic interaction has important role.

The nature of rivalry between firms determines marketoutcomes

Even markets with only two firms can produce verycompetitive outcomes

Bertrand model supports latter view

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3) Structure is itself endogenous.

Conduct affects structure: e.g. firms deciding to mergegenerate higher concentration

Performance affects structure: e.g. firms making losses haveto exit the market

The direction of causality is not clear

Market structure is not exogenous and treating it as suchleads to misspecification of regressions and biased orinconsistent results

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4) There are measurement issues.

Performance: accounting profit vs economic profit

Definition of the relevant market

Variables might belong to several categories (e.g. productdifferentiation is structure or strategy and thus conduct?)

Quantification of variables (e.g. how do we quantifycollusion?)

. . .

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Beyond the SCP paradigm

Although SCP paradigm is useful in a number of ways (e.g. toorganise information or even to organise the analysis . . . ),the response to the criticisms was recognition that structure is notthe most important determinant of the level of competition.Instead:

examine the logic and reasonableness of a firm’s conduct

explore strategic behaviour on a consistent basis

at the same time an analytic framework for examiningstrategic interaction emerged: Game theory

development of theories that focus primarily on strategy andconduct

field has been transformed, some call it: “New IndustrialOrganization”

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Main source for lecture today

Pepall, L., Richards, D. & Norman, G. (2010). ContemporaryIndustrial Organization. Wiley.Chapter: 1

Lipczynski, J., Wilson, J.O.S. & Goddard, J. (2013). IndustrialOrganization. 3rd edition. FT Prentice Hall.Chapter: 1

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lecture 1 handout

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