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Industrial Organization

Industrial Organization. Market Power Oligopoly models (homogeneous products). Market Power. Empirical questions of interest: What gives rise to market power? Assumptions: Market power can be measured reliably (cost data) Causality can be established “SCP” approach

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Industrial Organization

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  1. Industrial Organization Market Power Oligopoly models (homogeneous products)

  2. Market Power • Empirical questions of interest: • What gives rise to market power? • Assumptions: • Market power can be measured reliably (cost data) • Causality can be established • “SCP” approach • Is there market power? How much? • Cost data (i.e. market power) is unreliable • Use a lot theory and econometrics to infer unobserved cost (i.e. market power) • “Structural” approach

  3. Market Power • Empirical questions of interest: • What gives rise to market power? • Assumptions: • Market power can be measured reliably (cost data) • Causality can be established • “SCP” approach • Is there market power? How much? • Cost data (i.e. market power) is unreliable • Use a lot theory and econometrics to infer unobserved cost (i.e. market power) • “Structural” approach

  4. Structural Approach • “Structure”: • Theory • Start with oligopoly • Empirics: estimate theoretically meaningful parameters • Infer degree of market power

  5. Oligopoly Monopoly: No Rivals, full price control Oligopoly: Few firms, market price is affected but less than monopoly; this also affects rivals’ profits. Strategic environment: own strategy (and profits) depend on others’ strategies Perfect competition: Many firms, market price is unaffected by strategies. Not a strategic environment

  6. Oligopoly • Strategies: • Set prices • Set quantities • Popular models: • Cournot: quantity setting • Betrand: price setting • Stackelberg: price or quantity • Today: • Single period: a) Cournot, b) Betrand, c) Conjectural variation models • Later: • Repeated games (with collusion as equilibrium) Simultaneous Sequential

  7. Market Structures Perfect Competition P is given, choice of Q Imperfect Competition Oligopoly Decides P and Q given residual demand Duopoly Decides P and Q given residual demand Monopoly Decides P and Q given market demand Cooperation: Cartel/Collusion No-Cooperation Sequential Movements Leadership models Simultaneous movements Price Competition (Bertrand) or Quantity (Cournot) Repetitive interaction (∞)

  8. Cournot Model (1838) • Strategies are production levels • For now, assume 2 firms • What strategies should firm 1 use to choose output level? It depends on firm 1’ belief about firm 2’s behavior • Cournot: take rival’s choice as given

  9. Cournot (2 firms) $ B p=pM D1 (q2=0) D’ p’ D1 (q2=q2’) MC D MR Q q2’ q2’’ 1’s residual demand below MC: q1(q2’’)=0 q1(q2’) q1(q2=0)=qM

  10. Firm 1’s Reaction Function q2 q2’’ Optimal q1 given choice q2 Also known as “Reaction curve” or “best response” q2’ qM q1 q1(q2’)

  11. Cournot • Essence of Cournot Model: • Each firm treats output level of its competitor as given and then decides how much to produce • Each firm faces a residual demand curve • Reaction curve: describes optimal quantity choice given rival’s choice of quantity

  12. Cournot Equilibrium q2 q2, q1*(q2), is not a NE because firm 2 should reduce its output to increase profits r1 (q2) q2 NE: both choices are simultaneously optimal qM r2 (q1) q2*(q1*) qM q1 q1*(q2*) q1*(q2)

  13. Cournot: Algebra chain rule 1 0 This is the one of the Cournot assumptions

  14. Cournot: Algebra Additional profit of producing 1 more unit Reduced profit due to increased quantity • Cournot price < Monopoly price • Cournot profits (sum over all firms) < Monopoly profits • How is this related to the prisoner’s dilemma?

  15. Cournot: Algebra • Rewrite foc as: Market power is driven by market share

  16. Cournot • Joint profits are not maximized • Joint profit maximization happens when q1+q2=? And profits are ? • Not so realistic model: • Homogeneous products • Quantity competition • Simultaneous moves (one shot game, no equilibrium convergence)

  17. Bertrand: Price competition • Bertrand (1883): Who sets prices if not the firms? • Bertrand “conjecture” is similar to Cournot’s: rival’s price is taken as given (or fixed) • Consumers have perfect information • Firms have identical costs • Goods are homogeneous • No transportation costs • No capacity constraints

  18. Bertrand: example p1 Joint Profit Maximization π1=π2=5x10-5x3=35 10 • Assumptions: • 2 firms, MC1=MC2 • Unit demand, 10 consumers, each willing to pay a max of $10 • Lowest p captures the whole market, if tie, they split the market MC1=3 p2 MC2=3 10

  19. Bertrand: Example Joint Profit maximization π1=π2=5x10-5x3=35 (not an equilibrium) p1 10 • Strategies: price=[3,10] • Profit (πi): • (pi-3)x10 if pi<pj • (pi-3)x5 if pi=pj • 0 if pi>pj • Equilibrium: No incentive to change strategies Equilibrium: π1=π2=0 8 π1=0 π2=9x10-9x3=63 (not an equilibrium) MC1=3 45o p2 MC2=3 9 10

  20. Bertrand: More formally Why? A deviation must not be profitable pi>c means zero profit pi<c means negative profit

  21. Bertrand: Residual Demand r1(p2) p2 p2 Firm 2’ residual demand p1 r2(p1) MC2=3 q2 10 MC1=3 p1

  22. Bertrand Paradox • The perfectly competitive solution is found even in a highly concentrated market (2 firms) • It is hard to believe that firms in highly concentrated industries will not earn above normal profits • Solutions of the paradox: • Capacity constraints • Geographic differentiation (transportation costs) • Consumers have imperfect information • Product differentiation • Repetitive interaction

  23. So far… • Quantity setting firms (Cournot) • Price setting firms (Bertrand) • Conjecture or belief: “rival’s action is taken as given” • Bertrand, Cournot and Collusion can be “nested” in a more general model

  24. Conjectural Variation Model • 2 firms (n=2) “Conjecture”:

  25. n-firm Collusion and Bertrand • Symmetric case: q1=q2=…=qn n firms Collusion (monopoly): Bertrand:

  26. Conjectural variation: Elasticity

  27. Conjectural variation: Perceived MR MR • Oligopolist equates “perceived MR” with MC • Why “Perceived”: MR depends on conjecture about how firm 2 will react to a change in firm 1’s output

  28. Conjectural variation: Perceived MR p(Q) p(Q) Perceived MR of oligopolist Q “Weighted” MR: between monopolist’s MR and PC’s MR

  29. How is this done in practice? • Estimate supply and demand and infer from estimated parameters • Taking logs: Supply function (FOC optimality) Estimated constant Parameter of interest Demand estimate

  30. Conjectural Variation: Example “Perceived” MR

  31. Conjectural Variation: Example

  32. Criticisms of CV models • Conjectures are arbitrary • Certain values do not correspond to any theoretical model • Interpretation of CV models are implausible • Conjecture is a dynamic concept, but it is employed in a static (one-shot) framework • Firms do not update conjectures • Firms maximize PV of profits: choice of quantity/price today may not only affect today’s profits (this is a more general criticism)

  33. Popularity of CV Models • is known as “conduct parameter” • Why: Estimate of as an index of market power for the industry • Given criticism of conjectural variations, is not referred as CV in empirical analysis. Rather: index of market power

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