IO_2015

Industrial organiza/on

Axel Gau/er 2015

Industrial Organiza/on 1

Course overview

Part I: Oligopoly theory This first part reviews the main economic models of oligopoly compe77on. Part II: Market strategies In the second part, we analyze the strategies that firms use to maintain or increase their market power: pricing, innova7on, ver7cal rela7ons, product posi7oning… Part III: economics of the internet In the third part, we use the economic toolkit to analyze and understand the main features of compe77on in the digital economy


Course objec/ves

•  At the end of the course, you should be able to – Use and solve economic models of imperfect compe//on

– Understand the nature of strategic interac/on between firms

– Understand the concept of market power and the strategies used to increase/maintain it

– Use the economic models to have a beLer knowledge of the industrial organiza/on problems


Course organiza/on & Evalua/on

•  Class: Thursday 1.30pm-‐3.30pm •  4/5 homework •  Evalua/on: final exam (75%) and homework (25%)

•  Web plaYorm: Moodle/lol@ •  Contact informa/on:


Assistant Ekaterina Tarantchenko BAT B31, room I.54 [email protected] Tel 04/366.31.74

Prof. Axel Gau/er BAT B31, room I.49 agau/[email protected] Tel 04/366.30.53

Reference

•  Main reference for the course Belleflamme and Peitz ‘Market and Strategies’

Cambridge university press (2010) •  Other (good) textbooks in IO – Cabral ‘Industrial organiza7on’, MIT Press 2000 – Tirole ‘Theory of IO’, MIT Press 1998 – Lipczynski ‘Compe77on, Strategy, Policy’, Pren/ce Hall, 3rd edi/on 2009


PART I: OLIGOPOLY THEORY


Oligopolis/c industries

•  Perfect compe//on= large number of firms •  Monopoly= one firm •  In reality, markets are ofen served by a small number of firms


Strategic interac/on

•  The striking feature of oligopoly compe//on is strategic interac/on

•  Firms must incorporate in their decision making the an/cipa/on of how their compe/tors are likely to act and, to react to their own decisions


Ryanair Vs. Brussels Airlines

•  Low cost company •  Point to point model •  2nd largest European

company •  Irish, European network •  Turnover: 4325 m€ •  Passengers: 80m

•  Tradi/onal company •  Hub and spoke model •  Star alliance member •  Belgian, EU, Africa and

North America routes •  Turnover: 900m€ •  Passengers: 5m


Ryanair Vs. Brussels Airlines

•  In Nov. 2013, Ryanair announced the opening of 8 European routes from/to Brussels

•  Increase compe//ve pressures on SN BA •  Possible strategies for SN BA

1.  Price cut, new routes, cost culng But difficult to compete with the low cost model 2.  BeLer services, beLer connec/ons, product

differen/a/on Risky if consumers are sensi7ve to price

•  In Jan. 2014, SN BA opened 11 routes to challenge Ryanair


Part I: Three ques/ons


How do firms compete ? Price, quan/ty, quality…?

How can we measure the intensity of compe//on?

What are the factors that influence market power?

1

2

3

Outline Part I

1.  Monopoly and perfect compe//on 2.  Quan/ty compe//on: The Cournot model 3.  Price compe//on –  The Bertrand Paradox –  Capacity constraints –  Imperfect informa/on –  Product differen/a/on


Perfect compe//on

•  Large number of sellers and buyers No possibility to influence the market price

•  Homogenous products •  Symmetric informa/on Given the market price p, each firm selects the profit maximizing quan/ty as follows


maxqp.q−C(q)

⇒ p−C '(q) = 0

Perfect compe//on and IRS

•  A firm has increasing returns to scale if C(q)/q>C’(q)

•  Perfect compe//on is incompa/ble with IRS: If p=C’(q) then π<0

•  Structural factors of an industry could determine the nature of compe//on

•  More and more industries with IRS with the digitaliza/on of the economy (and 3D prin/ng) –  Large development cost – No or liLle produc/on cost


The monopoly problem

•  Demand func/on p(q), p’(q)<0 (‘law of demand’)

•  Using the defini/on of demand elas/city


maxqπ = p(q)q−C(q)

p(q)−C '(q) = −p '(q)q

η = −p(q)qp '(q)

p(q)−C '(q)p(q)

=1η

Measuring market power

•  Market power is defined as the ability to price above the marginal cost

•  MP is bounded above by the elas/city of demand

•  The Lerner index (L) measures the rela/ve price (marginal) cost margin


L = p(q)−C '(q)p(q)

Lerner index

•  The Lerner index is one measure of market power

•  It ranges from – 0 (perfect compe//on) to – 1/η (monopoly)

•  Alterna/ve measures (e.g. profit elas/city) •  Different from profitability (except for CRS) •  Link between market power and structural factors notably concentra/ons indices


Concentra/on indices

•  Herfindal index takes the sum of the square of the market shares (s)

•  Usually expressed as ranging from 0 to 10.000 •  Other indices: Ci – The sum of the market shares of the i-‐biggest firms


H = (si )2

i=1

N

∑


Concentra/on indices

HHI index: 613

Cournot oligopoly

•  Classical model of quan/ty compe//on – Each firm i chooses a quan/ty qi – The market clears at price p(Σiqi)

•  Assume –  Linear demand func/on P(Q)=a-‐bQ –  Constant marginal cost ci


Market power in a symmetric Cournot oligopoly

•  In a symmetric Cournot oligopoly, concentra/on is a good proxy for market power


H =1/ N

L = a− ca+ Nc

η = −dQdP

PQ=1bPQ=1Na+ NCa− c

Hη=a− ca+ Nc

= L

The Bertrand Paradox

•  Two firms with iden/cal marginal cost c •  Homogeneous product and price compe//on •  Demand Q(P) –  If p1<p2, Q1=Q(p1), Q2=0 –  If p2<p1, Q2=Q(p2), Q1=0 –  Ip1=p2, Q1=αQ(p); Q2=(1-‐α)Q(p)

•  Proposi/on: in the Bertrand duopoly, p1=p2=c (price war)


Bertrand compe//on

•  To escape the Bertrand paradox – Product differen/a/on – Cost uncertainty – Capacity constraint


Capacity constraint

•  Suppose that 2 firms compete in price •  Firm 1 has a capacity q1 •  Firm 2 has a capacity q2 •  Demand Q(P)=a-‐p •  Marginal cost of produc/on =0 •  Marginal cost of capacity = c •  Assume c<a<4/3c •  Timing of the game

1.  Firms choose their capacity 2.  Firms compete in price


Efficient ra/oning

•  Possible that demand exceeds capacity at some given price –  Consumers are ra/oned

•  Efficient ra/oning: consumers with the higher willingness to pay are served first

•  Alterna/ve ra/oning rules –  Random –  Propor/onal


Efficient ra/oning


Quan/ty

Price

Q(p)

p1

p2

q1 Q(p1) Q(p2)

Capacity constraint

Proposi/on: Under the efficient ra/oning rule and c<a<4/3c, price compe//on with capacity constraint is equivalent to Cournot compe//on Proof: Kreps and Scheinkman (1983) Remark: under other ra/oning rule, this result does not hold true.


NeYlix DVD by mail


Capacity choice: •  Copies of the latest movies

Pricing choice: •  Latest movies •  Back catalogue

Online movie rental

•  With high speed broadband connec/ons, the business has evolved to online movie ren/ng – No more capacity constraints – Entry of new compe/tors •  YouTube, Google TV…

– Compe//on on price and on quality (catalogues)

•  The technology has changed the nature of compe//on


Cost uncertainty

•  N firms compe/ng in price •  Cost of firm i in the interval [cL, cH] •  Firm i knows its cost ci

•  Firm i does not know the cost of the compe/tors but only the distribu/on

•  Proposi/on : with uncertainty on marginal cost, firms with cost c<cH choose a price above their marginal cost


PRODUCT DIFFERENTIATION


Horizontal product differen/a/on

•  Horizontal product differen/a/on: – Consumers have a non-‐unanimous ranking of the quali/es offered in the market


Samsung – Apple Pepsi-‐Coke Hoteling Model

Ver/cal product differen/a/on

•  Ver/cal product differen/a/on – All the consumers have an iden/cal ranking of the quali/es


Product differen/a/on

•  In models of product differen/a/on, consumers are heterogeneous

•  Construct the demand from the individual preferences

•  Modeling heterogeneous preferences is challenging – Loca/on models with transporta/on cost – Taste for quality


The Hotelling model

•  Model of horizontal product differen/a/on •  Loca/on model •  Consumers are located at some point x on the [0, 1] interval – Assump/on: Uniform distribu/on on [0,1]

•  The u/lity of a consumer x depends on – The value of the good ‘S’ – The price paid – The transporta/on cost


The Hotelling model

•  Two firms: A and B •  Firm A is located at a distance a from the lef

•  Firm B is located at a distance b from the right •  Firms produce at cost c≥0


The Hotelling model


0 1

a b

a 1-‐b

Firm A

Firm B

•  a is the ‘home market’ of firm A •  b is the ‘home market’ of firm B •  If the firms share the market, they compete for the 1-‐b-‐a consumers in between the two firms

U/lity

•  Linear transporta/on cost –  t transporta/on cost per unit of distance

•  U/lity of a consumer located in x is:

•  If S is large enough, the market will be fully covered (DA+DB=1)


U(x) =

S − pA -t x - a if he buys from A

S − pB -t (1-b) - x if he buys from B0 if the consumer does not buy

"

#$

%$

Demand func/ons

•  Three possible demand configura/ons – All consumers buy from A, DA=1, DB=0 – All consumers buy from B, DA=0, DB=1 – The market is shared, DA>0, DB>0

•  The market will be shared if the price differen/al does not exceed the transporta/on cost between the two firms


pA − pB ≤ t(1− b− a)

Demand func/ons

•  If the firms share the market, there is a consumer located in between the two firms that is indifferent between buying from A or from B

•  Demands addressed to firms are given by


S − pA − t(x̂ − a) = S − pB − t(1− b− x̂)

x̂

x̂ = (pB − pA )2t

+(1− b+ a)

2

DA = x̂, DB =1− x̂

Pricing equilibrium

•  The profit of firm i is equal to (pi-‐c)Di

•  Assuming market sharing, the first order condi/ons of the profit maximiza/on problem give:


∂π A

pA=pB − 2pA2t

+1− b+ a2

= 0

⇒ pA =pB2+t(1− b+ a)

2∂π B

pB=pA − 2pB2t

+1+ b− a2

= 0

⇒ pB =pA2+t(1+ b− a)

2

Pricing equilibrium

•  Solving, the market sharing equilibrium is given by:

•  Prices are strictly higher than marginal cost •  Profits are posi/ve


pA =t(3− b+ a)

3, pB =

t(3+ b− a)3

π A =t(3− b+ a)2

18, π B =

t(3+ b− a)2

18

Compara/ve sta/c

•  Prices and profit both increase with the transporta/on cost t

•  t can be interpreted as a measure of product differen/a/on – Low t, products are close subs/tutes – High t, products are highly differen/ated

•  Higher degree of product differen/a/on è Higher prices


Product posi/oning

1.  Home market effect – For given prices, the demand addressed to firm i increases with the size of its own market

–  Being closer to the compe/tor is a mean to increase its market share •  DA increases with a •  DB increases with b


Product posi/oning

2. Compe//ve effect –  When firms are closer to each others,

compe//on intensifies –  Price best responses increase with the size of the

home market

•  Op/mal product posi/oning trades-‐off these two dimensions


Product posi/oning

•  The profit πA increases with the size of the home market a

•  The profit πB increases with the size of the home market b

•  A firm increases its profit if it increases its home market

•  The home market effect dominates the compe//on effect

•  Reverse result if transporta/on costs are quadra/c Industrial Organiza/on 46

Aggressive pricing

•  If firm B chooses the price •  Firm A can

1.  Choose the price for a profit of

2.  Choose a price and capture all the demand: DA=1 and

•  If a=b, the market sharing equilibrium exists if a<1/4


π A =4b+ 2a3

pB =t(3+ b− a)

3

pA =t(3− b+ a)

3π A =

t(3− b+ a)2

18pA = pB − t(1− b− a) =

4b+ 2a3


•  Taste for quality parameter ‘θ’ – Distributed on the interval – Uniform distribu/on is a simplifying assump/on

•  Firms offer different quali/es s •  The u/lity of a consumer is formalized as

When he/she buys quality s at price p


[θ,θ ]

U(θ ) =θs− p


•  Two firms i=1,2, each one offering a good of quality si

•  Firm 2 is the high quality firm: s2>s1


θθ Demand for good 2

Demand for good 1

Higher taste for quality

IO_2015

Documents

quesons industrial organizaon

price compeon

market strategies

quanty compeon

strategic interacon

intensity of compeon

course belleflamme

course objecves