Econ 360 Midterm #1

Industrial Organization Is:

The study of the structure of firms and markets and their interactions. (Carleton & Perloff)

Grinnell Test (1966)

This period saw the development of the Grinnell Test. A two-pronged test for illegal monopolization: 1 the possession of monopoly power in the relevant market. 2 the willful acquisition of maintenance of that power as distinguished from growth or development as a consequence of a superior product, business acumen, or historic accident.

abuse theory of monopoly:

This theory is the notion that a monopolist will not be in violation of Section 2 of the Sherman Act unless they gained their monopoly by using abusive or oppressive business tactics.

T/F, A monopolist's price control implies that the marginal revenue function is different for the monopolist than it is for a perfectly competitive firm.

True

T/F, Firms and consumers are interdependent. All else equal, if prices rise firms earn more and consumers less.

True

T/F, Industrial Organization is concerned with how productive activities are brought into harmony with the demand for goods and services through some organizing mechanism such as a free market, and how variations and imperfections in the organizing mechanisms affect the success achieved in satisfying an economy's wants (Scherer)

True

T/F, Perfect competition is a benchmark for market performance. Why markets depart from this benchmark and how the departure diminishes social welfare is a major focus of policy.

True

T/F, Sometimes a market does not meet one of the assumptions needed for perfect competition and the market fails

True

T/F, Supply and Demand work together in the market to guide resources to their highest value use (i.e., invisible hand).

True

T/F, The FTC at times will simply examine whether or not entry has occurred as evidence of significant barriers to entry

True

T/F, The first step in any antitrust case is to identify the relevant market

True

Monopoly

When a firm (or a group of firms acting together) gains a significant amount of control over the market price.

Williamson Rule

a dominant firm increasing production in response to firm entry is evidence of predation.

Oligopoly

a market where there are a handful of similarly sized firms Examples: Soda industry (Coke and Pepsi), Airline industry, Auto industry, Cereal industry.

Strictly dominant strategy

a strategy that always has a higher payoff than the other strategies available to a player regardless of what her opponent does.

Strictly dominated strategy

a strategy that always has a lower payoff that the other strategies available to a player regardless of what her opponent does.

Demand

buyers that willingly buy products to maximize utility

Productive efficiency:

consumers are able to purchase the product at the lowest price consistent with the long-run survival of the firms in the industry

Perfect information

consumers are aware of all prices and all firms have access to the same production technology.

Homogenous products

consumers have no preference for any particular firm's output.

Intellectual Property

developing superior technology is expensive and investments in research should be protected by guaranteed monopoly to recoup those losses

The broad language of the Sherman Act gave:

economists a singular opportunity to shape antitrust policy

Antitrust policy:

legal rules that place constraints on firms' market activities in order to maintain, as far as possible, competitive market forces throughout the economy

Natural Monopoly

very low marginal costs but high fixed/sunk costs in combination with low demand relative to efficient scale

Product Tying

when a monopolist sells the product it has a monopoly with, tied to another product for which it originally had little of the market. This forces all the consumers that want the first product to have to buy the second product and pushes out competition for the second product.

Network Economies

when a product becomes better the more people use it. Most of the market coordinating on one product is better than everyone having a different one.

Introduction to Game Theory

• A game is a formal representation of a situation in which a number of individuals interact in a setting of strategic interdepence. • Strategic interdependence means that each player's utility depends not only on her own actions but also on the actions of the other players. • Game Theory gives us a very useful toolkit for thinking about markets with a small number of players which is relevant for discussing Collusion and Oligopoly settings. Every game must have three components: • Players, the economic agents who choose strategies in order to maximize utility (profit in the case of firms). • Strategies, contingent plans of action. A strategy is defined over all possible scenarios of the game that the players may have to make decisions on. • Payoffs, utility the players earn given the strategies they have chosen.

Reasons McGee's critique may not hold:

• A period of predatory pricing may drive down the rivals' price for selling their firms. • If an incumbent firm uses predatory pricing it may deter future entrants. (is it credible?) • Merging with intent to monopolize is illegal. Predatory pricing is also but more difficult for opponents to prove.

Nash Equilibrium

• A strategy profile is a combination of all the players strategies, e.g. (confess, confess), (scissors, paper) • A strategy profile constitutes a Nash equilibrium if no player is better off from unilaterally deviating (choosing a different strategy on their own). • Both players would be better off if they held out compared to (confess,confess) in the prisoners dilemma, but one cannot unilaterally deviate from (confess,confess) and be better off. • In a Nash Equilibrium, all players are best-responding to each others' best responses.

Sherman Act:

Sherman Act passed in the U.S. in 1890, outlawed "every contract, combination or conspiracy in restraint of trade" and "monopolization" and treated violations as crimes.

Allocative efficiency:

Society's marginal willingness to pay for the last unit of each good produced is equal to the marginal opportunity cost of that unit (price equals marginal cost).

Determinants of Supply:

Technology, this is a major determinant of production costs. E.g. agricultural goods are expensive if they rely on more manual labor rather than machines. • Factor Prices, if one of your inputs becomes more expensive then your price for a level of output goes up. E.g. gasoline prices closely follow crude oil prices. • Number of Suppliers, if there is a monopolist they can raise prices without fear of losing too much business. E.g. Comcast or Microsoft. • Weather, bad weather can damage crops or infrastructure, limiting their supply. (for a fun example, google "trading places orange juice futures" and read the Business Insider article).

Clayton Act

The Clayton Act (1914) made some practices explicitly illegal. One of them being Product Tying. The language of the Sherman Act was very broad and the Supreme Court interpreted it as giving the courts a lot of flexibility in applying it. • Congress did not like how flexible the courts interpreted the law, so they passed the Clayton Act which outlawed a few abusive business practices specifically.

Applying Sherman Act:

The court establishes the "rule of reason" approach. • Judges examine conduct on a case-by-case basis and determine whether they constitute reasonable business practices.

Post WWII Antitrust

The courts and government applied antitrust law very strictly in the post-war period

Supply

sellers that willingly sell products produced efficiently to maximize profits.

What drives intervention?

society not being satisfied with market outcomes

Barriers of Entry

something that keeps new firms from coming into a market that is generating economic profits.

Predatory Pricing

the act of a firm pricing below cost in a market in order to bankrupt rivals in that market

Absence of serious barriers to entry or exit

the costs of production are not higher for outsiders than for established firms

Perfect Competition

the perceived absence of control over price by any economic agent

Market Outcomes

the price and quantity combinations that result from the interaction of supply and demand forces

Market

"the set of suppliers and demanders whose trading establishes the price of a good"

Two Sections of Sherman Act:

1 Every contract, combination in the form of trust or otherwise, or conspiracy in restraint of trade... is hereby declared to be illegal. 2 Every person who shall monopolize, or attempt to monopolize... any part of the trade or commerce... shall be guilty of a felony...

Ways that entry can be prevented and ensure long-run monopoly profits:

1 Exclusive control over inputs 2 Economies of scale 3 Patents and Copyrights 4 Government license or Franchise 5 Network Economies (not in this book but important in the information age)

Needed for a firm to engage in predatory pricing:

1) Predatory firm must have a market share large enough to influence price levels significantly 2) Sunk costs must be low enough that firms being preyed on may be induced to leave. 3) Entry barriers must be high enough that new firms don't enter during the post-predation period.

Admissible evidence on product markets:

Buyers' perception that the two products are or are not substitutes. • Sellers' perception that the two products are or are not substitutes, specifically in business decisions. • Differences or similarities in the price movements of the products. • Differences or similarities in how the products are used or made.

Chicago School

By the 1970s the activism of the courts began to receive harsh criticism from legal scholars and economists. • The intellectual response originated mostly from the University of Chicago. • Aside from the break-up of AT&T, most cases favored alleged monopolists until the modern period. • The Chicago School Reaction was so influential that relatively few cases were even brought to court in this period.

Whats the relevant market?

Considering both parts and service: Consumers can't substitute for other service providers, market too large

Microsoft Market Definition

DOJ argued that the relevant market was Intel-compatible operating systems. • Microsoft argued the relevant market included the DOJ's definition in addition to Apple computers and "middle-ware" (e.g. Java virtual machine). • This was a typical market definition battle: plaintiff wants narrow definition and defendant wants broad definition. The district court ruled that the relevant market would be defined by the products that were "reasonably interchangeable by consumers for the same purpose". • Thus the court ruled the relavent market was only intel-compatible operating systems (all other PC operating systems, so only Linux and Windows).

How do we identify relevant markets?

Existence of substitutes or how easily a firm can raise prices profitably in an area are how we identify relevant markets

T/F, Industrial Organization is not concerned with explaining the gap between competitive and monopoly pricing

False

t/F, Defining the relevant geographic and product markets is easy in the real world.

False, Defining the relevant geographic and product markets is not so easy in the real world.

T/F, Firms and consumers willingly participate in the market. They would do so unless it made them better off.

False, Firms and consumers willingly participate in the market. They would not do so unless it made them better off.

T/F, Monopolists restrict output below maximum sustainable level to decrease prices

False, Monopolists restrict output below maximum sustainable level to increase prices and thus profits.

T/F, Network Economies have such a big effect of making consumers coordinate on one product that all video game consoles are sold at a price above average cost!

False, Network Economies have such a big effect of making consumers coordinate on one product that all video game consoles are sold at a price below average cost!

Standard Oil

Formed in 1870, Standard Oil quickly gained a large market share of Cleveland oil refineries by 1872. • Using unreasonable business practices, Standard Oil eventually gained a market share of 90% nationwide. • Discriminatory favors from railroads • Predatory pricing • Industrial espionage • Fake competitors

4 Assumptions:

Homogenous Products, Large numbers of buyers, perfect information, Absence of serious barriers to entry or exit

U.S. Steel (1920)

In 1901 a number of steel producers merged into U.S. Steel. Upon formation U.S. Steel enjoyed a 90% market share. • In the 1900s, the president of U.S. Steel, Gary, began inviting other steel manufacturers to his home for large dinner parties. Gary's friends tended to undercut his prices rather than collude with him. • By 1920 U.S. Steel's market share had fallen to 40%

Abusive and Exclusive Business Practices

Industrial Espionage, Fake Competitors, and Predatory Pricing (a.k.a. The Rockefeller Special) • Bundling • Raising Rivals Costs (e.g., cornering input market or buying distributors) • Product Tying

McGee Critique:

John McGee challenged the economic foundation of predatory pricing: • It would be more beneficial for the dominant firm to buy out competitors rather than use predatory pricing. • Rivals have an incentive to sell because the dominant firm will offer a portion of the future monopoly profit in the purchase price. • Dominant firm has an incentive to offer a high purchase price because it will be able to save losses from predation and earn monopoly profits immediately.

Kodak Decision

Kodak's market share was determined to be almost 100% in this case as the relevant market was only Kodak replacement parts, which were being illegally tied to service. • Guilty. Kodak was forced to allow its parts manufacturers to sell replacement parts to ISOs.

Breadth of government intervention:

Labor (e.g. minimum wages) • Land use (e.g. zoning laws) • Environment (e.g. Clean Air Act, logging permits) • Prices (e.g. electricity prices) • Mergers (e.g. American Airlines and US Airways) • Advertising and Labeling (e.g. tobacco commercials, nutrition facts)

How is market outcomes manipulated?

Legislation is passed (or rules within regulatory agencies changed)

Microsoft's Exclusionary Conduct

Made agreements with equipment manufacturers (e.g., Compaq, HP, Gateway) to restrict placing alternative browsers on retail computers. • Tied Internet Explorer to Windows and sold it at a "negative price". • Microsoft argued that its producing of Internet Explorer at low cost benefited consumers and it was simply being competitive.

Sources of Microsoft's Monopoly

Network Economies: • Coordinating on one operating system will mean more programs will be written for it. • Professionals can spend their time improving their expertise in one system rather than learning multiple ones. Economies of Scale: • Operating systems require a huge amount of man hours to code and create. Big fixed cost. • It is relatively cheap to distribute software. Small constant marginal cost. • This implies that the average cost of supplying an operating system consistently falls the more people buy it.

Negatives to antitrust intervention (Blair and Kaserman):

Not all monopolies necessitate a government response because the cost of litigation may be greater than the benefit. E.g. a lone barber in a secluded town. • Time may be all that's needed for the market to correct itself. New firms may enter (or technological change occurs) or consumers may adjust to the higher prices. • Information age competition is dynamic and explosive (virality), antitrust policy needs to take this into account.

Agreeda-Turner Rule:

Pricing below marginal cost, when MC is below ATC, and pricing below ATC, when MC is above ATC, is evidence of predation.

Large number of buyers and sellers (Price Taking)

one firm's production or one buyer's consumption is not enough to change the equilibrium price.

The commands of the Sherman Act were:

open-ended and gave federal judges extraordinary power to draw the lines between acceptable cooperation and collusion as well as competition and monopolization

Superior Efficiency

perfect information fails and one firm has far better productive technology.

Baumol Rule

predatory pricing is only profitable if firms can raise prices in later periods, therefore firms should not be allowed to raise prices for a certain period of time after a price decrease.

Negatives to regulation in general:

• Costs. Buildings and staff for regulatory agencies are expensive and the productive capacity of those resources are lost. • Inadequate feedback. There is no market mechanism forcing the costs of the regulatory agency to be more efficient and to maximize social welfare. • Inability to gauge performance. Firms act to maximize profits. The goals and measuring the performance of regulatory agencies are vague. • Interest groups. Business lobbies can "capture" regulators and influence them to support the firms' interests. Aka "rent-seeking".

Kodak Case

• Eastman Kodak produced copiers that required regular maintenance and repair parts. • Independent service organizations (ISOs) began to offer repair services and compete with Kodak. • ISOs bought their parts from Kodak manufacturers and charge cheaper labor costs. • Kodak stopped selling replacement parts to ISOs and would only sell parts to customers if they purchased the service from Kodak as well.

Microsoft vs US (1999)

• In the mid-1990s many firms were accusing Microsoft of maintaining this share through exclusionary practices. • The specific practice in question was the act of tying the Windows operating system to Internet Explorer (web browsing application). • Microsoft's major competitor in the web-browsing market was Netscape DOJ applied the Grinnell approach in accusing Microsoft of illegally monopolizing the operating system market. • Microsoft argued that competition in the software industry was inherently different from other markets. • This "dynamic" view of the market argued that software is characterized by a research and development period and followed by a period where the best product wins most of the market.

Determinants of Demand:

• Income, have positive or negative effect (normal or inferior good) • Tastes, also can be positive or negative. (e.g.) Some cultures prefer watching tv from beds rather than couches. • Prices of Substitutes and Compliments, positive and negative effects respectively. • Expectations, what if price in the future will go up? Maybe I'm better off buying today. • Population, more people means more demand.

Four Causes of Market Failure

• Limited Competition (monopoly or oligopoly). Which we are primarily concerned with in this class. • Public goods. Social benefit is greater than private benefit and thus underprovision typically occurs. • Information Asymmetry. • Externalities (e.g. pollution)

Microsoft Decision and Consequences

• Microsoft was found to have a significant share of the relevant market (95%) and also priced Windows 98 well above a financially feasible price while simultaneously raising the price of Windows 95 upon the release of 98, demonstrating Microsoft's pricing power. (First prong of Grinnell test satisfied) • The district court ruled that Microsoft's product tying conduct was intended to prevent competition. (Second prong of Grinnell test satisfied) • Guilty. District court rules to split Microsoft into two companies! One with Internet Explorer, the other with Windows. • The Court of Appeals overturned the decision of the district court to have the Windows and Internet Explorer portions of Microsoft split.

Admissible evidence on geographic markets (DOJ/FTC guidelines):

• The shipment patterns of firms. • Evidence of buyers actually buying from different geographical regions. • Differences or similarities of price movements that can't be explained by changes in income or costs. • E.g., if demand increases for one good but not another, they are probably not substitutes Transportation costs. • Costs of local distribution. • Excess capacity of firms outside the area. • Excess capacity indicates firms are not part of the region

United States Machinery Corporation vs US (1953)

• United Shoe would lease out their machines for 10 years at a time and include full repair service with the lease. • These long-term lease agreements were found by the court to unnaturally create barriers to entry as they made it difficult for customers to switch over to competitors' machines. From a certain perspective, the leases minimized risk that small shoe makers had to take on when buying equipment. • Many customers had testified that they approved of United Shoe's lease policy. Guilty • This further hints that the trend at the time was for the court to rule against monopolies gained in any form.

Antritrust laws can be enforced with:

fines, jailtime, market restructuring (like AT&T) and order firms to cease anticompetitive behavior