industrypartsa/b 1

Economics of industry

The economic consequences of market power, the foundations of

industrial policies

industrypartsa/b 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 firm’s 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.

industrypartsa/b 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.

industrypartsa/b 4

L&W 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)

industrypartsa/b 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/ M&As discussed later

industrypartsa/b 6

Economic consequences of firm s/e/p market power ?

• For firm’s 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 M&As?

industrypartsa/b 7

Watch the words• What firm’s 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, aren’t even considered. Firms don’t 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.

industrypartsa/b 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.

industrypartsa/b 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.

industrypartsa/b 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.

industrypartsa/b 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.

industrypartsa/b 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.

industrypartsa/b 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’.

industrypartsa/b 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).

industrypartsa/b 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.

industrypartsa/b 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 > 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.

industrypartsa/b 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.

industrypartsa/b 18

Monopoly and alloc. efficiency

• Diagram one (at lecture)

industrypartsa/b 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

industrypartsa/b 20

Organisational effic

• Diagram two

industrypartsa/b 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.

industrypartsa/b 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.

industrypartsa/b 23

Arrow’s 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 R&D 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!

industrypartsa/b 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, couldn’t the competitive incentive to seek one be seen as harmful or wasteful? (see the Posner bit later)

industrypartsa/b 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 ….

industrypartsa/b 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.

industrypartsa/b 27

Quality diagram • Diagram 3

Value ofincreasesin quality

Quality

industrypartsa/b 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.

industrypartsa/b 29

Is this suspicious?

• If a ‘comp’ firm fills each quality space available wouldn’t 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?

industrypartsa/b 30

Posner’s 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 R&D, advertising, acquire competitors, etc to win and maintain m power.

industrypartsa/b 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! (It’s 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.

industrypartsa/b 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.

industrypartsa/b 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 R&D competition.

industrypartsa/b 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?

industrypartsa/b 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.

industrypartsa/b 36

Posner’s 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.

industrypartsa/b 37

Call that a case?

• So that’s 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.

industrypartsa/b 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.

industrypartsa/b 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 that’s a different game!

industrypartsa/b 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!

industrypartsa/b 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.

industrypartsa/b 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 consumer’s 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.

industrypartsa/b 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 isn’t 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?

industrypartsa/b 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.

industrypartsa/b 45

‘New economy’ critique of MP• A group of authors/consultants argue that the nature of

new economy (1990’s 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), D’Aveni (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.

industrypartsa/b 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.

industrypartsa/b 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).

industrypartsa/b 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 L&W on this, chap 6.2

industrypartsa/b 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.

industrypartsa/b 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 doesn’t 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.

industrypartsa/b 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.

industrypartsa/b 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).

industrypartsa/b 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.

industrypartsa/b 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.

industrypartsa/b 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?

industrypartsa/b 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?

industrypartsa/b 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 doesn’t apply. VW cars don’t 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.

industrypartsa/b 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 what’s available? Or product proliferation in cereals/ toiletries etc which could be seen as improving consumer choice.

industrypartsa/b 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.

industrypartsa/b 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.

industrypartsa/b 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.

industrypartsa/b 62

Diagram 4 : Price discrimination Explanation in lecture

P

Q

industrypartsa/b 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

industrypartsa/b 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.

industrypartsa/b 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?

industrypartsa/b 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?

industrypartsa/b 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.

industrypartsa/b 68

Williamson’s diagram

• D 5 in the lecture

industrypartsa/b 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.

industrypartsa/b 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 doesn’t actually change, and the cost increase is pure transfer (from owners to employees). The social loss of monopoly isn’t increased.

industrypartsa/b 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 isn’t 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?

industrypartsa/b 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?

industrypartsa/b 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

industrypartsa/b 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!)

industrypartsa/b 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.

industrypartsa/b 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.

industrypartsa/b 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 can’t 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 L’Oreal.

industrypartsa/b 78

• In this case the monopolist’s 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.

industrypartsa/b 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 customer’s 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?

industrypartsa/b 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.

industrypartsa/b 81

9. Mon and innovation • Does mon power really harm innovation (dynamic

effic) as Arrow’s 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.

industrypartsa/b 82

Comp for the market v comp in the market

• An important distinction to keep in mind. • What is the key issue in R&D/ 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 doesn’t stop competition FOR that market by others investing in R&D.

• 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 R&D and if one comes up with something better, can then compete in the market or itself become the dominant supplier.

industrypartsa/b 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?

industrypartsa/b 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

industrypartsa/b 85

Some characteristics of investment in R&D• 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.

industrypartsa/b 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 R&D pipeline many of which are unlikely to make it. Average R&D 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.

industrypartsa/b 87

Markets and R&D/ innovation• What is likely to promote the ‘best’ level of investment in

R&D socially speaking?• Note immediately that competitive markets driven by the

profit motive can’t 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 R&D exceeds the private (eg because of spillovers), and the social costs of R&D is less than the private (eg because of taxes). So society will favour more R&D than comp markets will promote.

industrypartsa/b 88

R&D 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?

industrypartsa/b 89

• Second, possibly too much competition will reduce R&D 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, R&D is in practice largely financed from business profits. But highly competitive markets don’t allow for above normal profits. So how can firms finance R&D? Some economists have argued that for this reason market power will encourage innovation rather than harm it.

industrypartsa/b 90

• Third, too much competition may reduce R&D 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.

industrypartsa/b 91

• Fourth: mon incentive to innovate may be stronger than Arrow allowed for because in practice it knows that if it doesn’t innovate its current profits can eventually be eroded by an innovating entrant. This is R&D 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.

industrypartsa/b 92

• Fifth, a monopolist may even over invest in R&D 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 else’s 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.

industrypartsa/b 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.

industrypartsa/b 94

• Finally, too much competition might harm the realisation of significant economies of scale&scope in R&D 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 couldn’t 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 R&D).

industrypartsa/b 95

The Schumpeter hypothesis• A combination of some of the above arguments

was in fact first put forward in the 1940’s by Joseph Schumpeter and much of the subsequent debate in the area has referred back to his ideas (and of course Arrow’s).

• 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.

industrypartsa/b 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.

industrypartsa/b 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

industrypartsa/b 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.

industrypartsa/b 99

John Kay’s 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.

industrypartsa/b 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.

• PC’s, memory chips, selling on the internet, mobile phones, budget airlines, ….

industrypartsa/b 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

industrypartsa/b 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.

industrypartsa/b 103

Competition processes• Imitation/ replication: good ideas, products, services get copied/

imitated rapidly(often even patents aren’t 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.

industrypartsa/b 104

Processes cont. • Deregulation/ liberalisation: established monopolistic positions

(often granted by state fiat) are opened up, eg airlines, water, postal services, electricity, telecoms….

• Globalisation: increasing penetration of national markets by international firms: autos, telecoms, financial services, electricity.

• Information (and communication) costs: are falling as a result of technology. Increasing price visibility and value comparability. Look at car buying for example, or bookselling, or electrical goods, or travel.

• Integration: suppliers integrate forward (Msoft into game consoles), customers integrate backwards (Dell into producing peripherals?)

• Other factors at work: More demanding, better informed, consumers (What computer, What hi fi etc).

industrypartsa/b 105

Competition for the market• 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?

• VI uses target pricing to build volume and target costing to ensure good margins.

• 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. Harvard BR, 2000, Sloan MR 1999

industrypartsa/b 106

Market space v market share• Competition is now about max. your share of consumer

spending (market space) not specific product market share. • Seeking to ensure longevity (loyalty), depth, breadth, and

diversity of spending. • BP for example seeks to sell ‘energy solutions’ not just oil.

Unilever no longer just sells cleaning products but markets cleaning services/solutions. Lego embraced the possibility of computer games which had threatened its traditional business. Virgin offers a comprehensive door to door service not just a flight. Ford is no longer just about ‘pushing the metal’ but total product/ service packages.

• Sloan management review, 2000

industrypartsa/b 107

‘Perfect’ competition • Is really the antithesis of competition as we know it. So

referring everything to the idealised model is misleading. Competition in practice IS about seeking advantage by methods such as product diff and development, innovation, quality improvements, ….not just price. Markets conforming to the idealised model are rare. A world like it would perhaps not be very perfect at all. In any case comp doesn’t have to conform to the perfect model to be beneficial. Otherwise capitalist economies wouldn’t be super-rich.

industrypartsa/b 108

Sum up on m power • So we have it. The textbook model of mon is

based on a set of quite extreme, possibly dubious, assumptions which ‘strain credulity’ and which weaken the universality of the naïve ‘harmful’ result. We do not seek to show m is good, just that it may not be, on balance, as ‘harmful’ as the mainstream two dimensional model suggests.

• But this is not end of story, next we should consider oligopoly markets, what happens between the two extreme models. Then of course look at the empirical evidence on these issues.