Industrial Organization

Week 1. Lecture 2. Overview of IO

Mikhail Drugov

New Economic School - Egor Gaidar Foundation

Summer School

27 June 2017

Industrial Organization, Week 1, Lecture 2 1 / 48

Overview of Industrial Organization
I. Basics
a. Perfect competition, monopoly, dominant …rm
II. Market Power
a. Static imperfect competition
b. Dynamic aspects of imperfect competition
III. Sources of Market Power
a. Product di¤erentiation
b. Advertising
c. Consumer inertia
IV. Pricing Strategies and Market Segmentation
a. Group and personalized pricing
b. Menu pricing
c. Intertemporal price discrimination
d. Bundling and tying
V. Product Quality and Information
a. Asymmetric information, price and advertising signals
b. Marketing
Industrial Organization, tools2 for experience goods
Week 1, Lecture 2 / 48
Overview of Industrial Organization cont.

VI. Theory of Competition Policy

a. Cartels and tacit collusion
b. Horizontal mergers
c. Strategic incumbents and entry
d. Vertically related markets
VII. R&D and Intellectual Property
a. Innovation and R&D
b. Intellectual property
VIII. Networks, Standards and Systems
a. Markets with network goods
b. Strategies for network goods
IX. Market Intermediation
a. Markets with intermediated goods
b. Information and reputation
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Overview of Industrial Organization cont.
Behavioural IO

I Very recent and hot topic (not yet in textbooks)

I Consumers may have:
I Non-standard preferences
I reference-dependent preferences
I strange time preferences (hyperbolic discounting)
I Wrong beliefs / updating rule
I most people think they are better than the average
I overweight the evidence from small samples
I don’t use the Bayes rule
I unaware of many things
I Non-standard decision making
I use rules of thumb and heuristics
I are in‡uenced by impulse, emotions, manipulations, framing
I See Ran Spiegler (2011) Bounded Rationality and Industrial
Organization, Oxford University Press
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III. Sources of Market Power
Advertising

I In 2006 in the US 2.2% of GDP was spent on advertising

($952 per capita)
I The biggest advertiser Procter and Gamble spent $4.9 billion
on advertising in the US (17% of its North-American sales
and 7% of its worldwide sales)
I Types of advertising:
I Persuasive: alters consumers’tastes; ampli…es product
di¤erentiation and consumers’loyalty to a particular brand
I Informative: provides consumers with information about the
existence, prices and characteristics of products, either directly
or indirectly
I Complementary: consumers directly derive utility from
advertising in a complementary way to the consumption of
other products

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III. Sources of Market Power
Advertising

I In general, persuasive advertising makes the demand less

elastic
I Informative advertising does the same when consumers learn
about the …t of the products
I If they learn about the existence of the product, demand
elasticity does not decrease
I How to distinguish between informative and persuasive
advertising?
I Persuasive advertising should a¤ect all the consumers
I Informative advertising should a¤ect only inexperienced
consumers

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III. Sources of Market Power
Advertising

I Advertising softens competition if it informs consumers about

the existence, characteristics and prices of products, or when
it increases the perceived di¤erences between brands
I It makes competition tougher if it mainly helps …rms steal
each other’s business
I There is a long debate if advertising contributes to the social
welfare. It depends a lot on a particular model (what
advertising exactly does, how …rms compete, etc.)

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III. Sources of Market Power
Consumer inertia: uninformed consumers

I Consumers may be locked in for various reasons

I First, they might not know about the existence of other …rms
I Suppose some consumers are informed and know about the
existence of both …rms while others are not and know only
about one …rm
I Spatial price dispersion:
I One …rm sets a high price targeting its uninformed consumers
I The other …rm sets a low price targeting its uninformed
consumers and informed consumers
I Temporal price dispersion:
I Firms play mixed strategies
I Uninformed consumers buy at the price from “their” …rm
I Informed consumers compare the prices of di¤erent …rms and
buy at the lowest price
I Note that there is price discrimination at the level of the
industry due to information asymmetries across consumers
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III. Sources of Market Power
Consumer inertia: search

I Diamond paradox (1971 JET)

I Suppose consumers know about the existence of all the …rms
but know the price at only one of them (their “local” …rm)
I They can learn other prices at some cost
I The unique equilibrium: all the …rms charge the monopoly
price, consumers do not search
I It holds for any positive level of search cost, however small

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III. Sources of Market Power
Consumer inertia: sequential search

I Some consumers are informed

I Others are not and search sequentially:
I At each …rm they decide whether to learn the price of one
other …rm, at a cost
I In the equilibrium …rms mix over the prices and consumers
search until they encounter a low enough price (or there is no
…rm left)
I As the share of informed consumers increases, the distribution
of prices becomes more concentrated near the competitive
price
I Search models are complicated, results are often ambiguous
I For example how does price dispersion depend on the search
cost?
I There is price dispersion, and sometimes quite considerable,
even in online markets
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III. Sources of Market Power
Consumer inertia: switching cost

I It is sometimes costly to change the …rm

I Various kinds of costs: transactional, contractual,
compatibility, learning, uncertainty, psychological
I Rational consumers understand that they will locked on and
exploited later (unless the …rm can commit on the future
terms)
I They demand a discount in the beginning of the relationship
I In a monopolized market, switching costs do not change
anything
I With several …rms, switching costs can soften or strengthen
competition depending on the details of the model

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III. Sources of Market Power
Consumer inertia: switching cost and consumer poaching

I SAP and Oracle are two major competitors on the market for
business automation software
I Oracle started in 2005 to expand via the acquisition of smaller
rivals
I SAP’s reaction was to implement its so-called “safe passage”
programme, aimed at customers of companies acquired by
Oracle and worried about future support and development
I As part of the o¤er, SAP o¤ered them a large credit toward
the purchase of comparable SAP software

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V. Product Quality and Information

I Three types of goods (Nelson 1970 JPE)

I Search goods: characteristics of the good can be understood
by consumers before the purchase (use)
I Experience goods: characteristics of the good can be
understood only after the purchase (use)
I Credence goods: characteristics of the good cannot be
understood even after the purchase (use)
I Here, the analysis typically concerns the experience goods

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V. Product Quality and Information

I Asymmetric information: the seller knows the quality of the

good, the buyers do not
I Used cars (Akerlof, 1970 QJE: “The Market for ’Lemons’:
Quality Uncertainty and the Market Mechanism”)
I Genesove (1993 JPE): wholesale auctions for used cars in the
US
ITwo types of sellers: new car dealers (NCD) and used car
dealers (UCD)
I NCDs have more trade-ins
I UCDs have retail demand for used cars that are close

substitutes for new cars

) NCDs have better cars on average other things being equal
) They enjoy a premium compared to UCDs (though small)
I Also, used cars that had only one owner are sold at a premium

compared to those that had two owners

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V. Product Quality and Information

I Suppose that in a market there are two possible quality levels

I Sellers are privately informed about them
I The buyers are ready to pay up to the expected quality
I If the costs of high quality sellers are above the average
quality, they refuse to sell
) Only low quality goods are sold
) This is “market breakdown”
I If there are many quality levels, it is still possible that only the
lowest quality is traded

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V. Product Quality and Information

I Another problem is when the quality is endogenous

I Take the previous model and suppose that the sellers can
choose which quality to produce
I Producing high quality is e¢ cient: social value (= buyers’
valuation minus the cost) is higher
I But clearly the sellers will produce only low quality

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V. Product Quality and Information

I The high quality sellers (and the social planner) do not like
this outcome
I What can they do?

1. Directly reveal the quality

I But it has to be done in a credible way (certi…able/veri…able
information)
2. Provide warranties
3. Signal the quality
I Warranties
I Advertising
I Price
I Restricting sales
4. Reputation, branding
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V. Product Quality and Information
Providing (credible) information

I In many instances the sellers have to provide certain

information truthfully (annual interest rate on a loan)
I Or they can choose to disclose truthfully or say nothing
(auditors’/consultants’report)
I Sometimes it works in unexpected settings
ILewis (2011 AER): selling used cars on eBay
ISellers can choose which information to provide
I Sellers prefer to disclose good information

) Cars about which more information (number of photos,

number of bytes in provided information, some particular
words) is provided are sold at a higher price

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V. Product Quality and Information
Warranties

I Hyundai in the US o¤ers warranties that deviate from the

industry average
I in 2006, Hyundai o¤ered a 10-year or 100 000-mile protection
plus a 5-year or 60 000-mile bumper-to-bumper protection
I On top of this comes a 5-year unlimited roadside assistance on
all new vehicles
I As a result, Hyundai sales have soared and repeat customers
increased
I Warranties directly increase the valuation (for example, if
buyers are risk averse)
I Or signal quality

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V. Product Quality and Information
Signalling

I A …rm may be able to signal its quality by some observable

action if
I the costs of this action are lower for high quality sellers
I or the bene…ts are higher for high quality sellers
I Examples:
I Warranty: high quality sellers have lower costs of o¤ering
warranty
I Advertising: the costs are the same but the bene…ts are higher
for high quality sellers if their customers are more likely to
come back (thus, repeated purchases are required)
I High price: if some consumers are informed, setting a high
price is costly for a low quality seller as it will not sell to them
I Restricting sales: high quality …rm may restrict sales if the low
quality seller prefers then to sell a lot at a lower price

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V. Product Quality and Information

I Anderson et al. (1999 Prod. Oper. Man.): why do …rms

adopt ISO 9000 standards?
I Proponents: it is useful to increase the quality and to signal it
I Critics: “a paper exercise that adds to bureaucratic waste”, a
barrier to market entry in countries where it is a regulatory
standard; there are better or cheaper ways to increase quality
I Sample of US …rms some if which have adopted ISO 9000 and
others have not
I They …nd that adopting ISO 9000 does serve a signalling role

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VI. Competition (Antitrust) Policy
History: US

I End of XIX century: improvements in transportation and

communication intensi…ed competition
I After some price wars, …rms started to form cartels and trusts
I Sherman Act (1890): price agreements among competitors
are illegal
I Clayton Act (1914): mergers to reduce competition are not
allowed
I Enforcement has been changing too:
I Between WWI and WWII (especially, after Great Depression):
abuses are tolerated as industries struggled to survive
I After WWII until the 70s: very interventionist and extreme
I 1970-80s: Chicago School: some practices have e¢ ciency
reasons, “free market”
I 1990s-now: somewhere in the middle

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VI. Competition (Antitrust) Policy
History: Europe

I Proper laws in most countries appeared only after the creation

of the EEC (1957)
I UK: 1919: attempt to reduce prices after WWI, amended
after WWII to reduce unemployment. Until 1998: no clear
objective, no strong enforcement
I Germany: early XX century: cartels were enforced in courts;
Cartel Law (1923): to reduce prices due to hyperin‡ation,
however, not strictly enforced - the idea of “national
champions” to compete abroad. After WWI: Allies pushed for
strong laws to break up these …rms (as in Japan)
I Also, US wanted stricter laws for Europe in general while state
interventionism was still high
I Currently, Articles 101 and 102 of the (Lisbon) Treaty of the
European Community
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VI. Competition (Antitrust) Policy
Comparing US and Europe: Virgin vs. British Airways (BA) (early 1990s)

I
BA promoted its ticket sales by o¤ering travel agents
additional …nancial incentives on top of the standard
commissions if they sold more of its tickets
I BA was dominant in this market
) Virgin complained (before the European Commission in 1993
and before a US court in 1994) that BA’s scheme was
anticompetitive and predatory because it was reducing the
travel agents’incentives to sell tickets of competing airlines
I US: complaint rejected on the ground that Virgin had failed
to demonstrate any adverse e¤ects on competition (such as
increased prices, reduced quantity or quality). It was indeed
stressed that what matters in such cases is the harm to
competition rather than the harm to a speci…c competitor
I EU: accepted: a dominant …rm is not allowed to o¤er
discounts to encourage loyalty (it can only do it for e¢ ciency
reasons, such as cost savings from large orders)
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VI. Competition (Antitrust) Policy
Comparing US and Europe: in general

I In the US economists play a larger role in the competition

policy
I The focus is more on consumer welfare, in Europe - on
competition per se
I Harsher punishments in the US
I However, the di¤erences are decreasing
I Economists now play a larger role in Europe than in the past
I Leniency programs started in the US, but are now more and
more used in Europe

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VI. Competition (Antitrust) Policy
Collusion

I See The Informant! (2009): collusion in the lysine market

I Vitamin cartel
I In Europe, sales of bulk vitamins were EUR 800 mln in 1998
(Ho¤mann-La Roche, has a market share of 40 to 50%, BASF
has 20 to 30% and Aventis, 5 to 15%)
I On 21 November 2001, the European Commission imposed a

then record …ne of EUR 855.22 million on eight companies for

participating in secret market-sharing and price-…xing cartels
I Overall, the Commission assessed the existence of eight

distinct cartels involving di¤erent vitamins between September

1989 and February 1999
I This European case followed an investigation by the US, which

in 1999 had already led to Ho¤mann-La Roche pleading guilty

and paying a $500 mln criminal …ne for leading a worldwide
conspiracy to raise and …x prices and allocate market shares for
certain vitamins sold in the United States and elsewhere.
BASF too pleaded guilty and paid $225 million in …nes. In
addition,
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Lecture 2were large payments in civil settlements 26 / 48
VI. Competition (Antitrust) Policy
Collusion

I Two types of collusion:

I Explicit collusion: …rms meet, share information, discuss what
to do (set prices, share markets, etc,), possibly use transfers
I most detected / proven cartels
I Tacit collusion: …rms do not meet, do not share information
but understand how to collude
I Most theoretical work is about this type
I How / when do cartels form?
I Free-riding of non-participating …rms
I Simultaneous / sequential formation

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VI. Competition (Antitrust) Policy
Collusion

I When is collusion stable (i.e., is an equilibrium of a repeated

game)? How is it a¤ected by di¤erent factors?
I Number of …rms, …rm asymmetry, demand uncertainty,
imperfect observability, cyclical demand, multimarket contact,
etc.
I Leniency: relatively new and important instrument
I The …rm that reports and provides evidence is rewarded by a
lower punishment
I Also, for individual informants
I How to design a leniency program? How does a¤ect cartel
formation and stability?
I How many …rms to reward? What is the size of the reward?
Should the ring leader be exempt from the leniency?

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VI. Competition (Antitrust) Policy
Horizontal mergers

I In 1998, Superior Propane Inc. and ICG Propane Inc. were

the two largest distributors of propane in Canada
I They wanted to merge
I Canada’s Commissioner of Competition was against: the
merger would substantially lessen competition in 66 of 74 local
markets (and even create a monopoly in 16 of them)
I Estimated deadweight loss from reduced competition (long live
econometrics!): C$6 million per year over a ten-year horizon
I But cost e¢ ciencies of C$29 million per year over the same
horizon
I Competition Tribunal allowed the merger
I Court of Appeal rejected the unquali…ed application of the
total surplus standard, requiring instead that a larger weight be
placed on consumer surplus

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VI. Competition (Antitrust) Policy
Horizontal mergers

I When should a merger be allowed?

I A merger reduces competition but may increase e¢ ciency
(economies of scale, synergies)
I Which welfare standard to use, total welfare or consumer
surplus
I How can a merger be modi…ed to be allowed?
I Sell some brands / facilities, agree to some contracts
I A merger may make collusion more likely
I A merger can trigger another merger

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VI. Competition (Antitrust) Policy
Strategic incumbents and entry: Kodak vs. Fuji

I US market for photographic …lm

I Up to 1970s: dominated by Kodak
I Fuji managed to enter in 1980: 5% market share
I Fuji’s entry was …rst deterred and then accommodated by
Kodak
I Why and how? Kadiyali (1996 Rand)
I Deterrence
I Kodak was limit pricing (low prices) and limit advertising (high
budget)
I If Fuji had imperfect information on either market demand or
Kodak’s costs, Kodak could choose low prices and high
advertising budgets to indicate low costs of production

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VI. Competition (Antitrust) Policy
Strategic incumbents and entry: Kodak vs. Fuji

I Fuji managed to enter in 1980: 5% market share

I Accommodation
I Strategic variables: price and advertising are complements
I Incumbent is better o¤ not acting in an aggressive way
I Kodak was in a position to cut its price but did not do so;
also, Kodak’s advertising aimed at expanding the market not
at stealing business from Fuji

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VI. Competition (Antitrust) Policy
Strategic incumbents and entry

I The zoo of Fudenberg and Tirole (1984)

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VI. Competition (Antitrust) Policy
Vertically related markets: Selling spices in Belgium

I In the 1970s, four producers together had 85% of the market

for spices; the largest …rm, Liebig, had 39%
I The three largest supermarket chains contributed 60% to
Liebig’s sales
I According to their agreement with Liebig, these three chains
exclusively sold spices by Liebig (and own brand spices),
charged the retail price set by Liebig (RPM) and displayed
Liebig spices prominently
I Liebig in return granted annual rebates, sales incentives and
guaranteed a minimum pro…t (as agreed with the chain)
I The European Commission found that the agreement
restricted inter-brand competition because no other brands
other than Liebig and the own brand could be sold. The
…nancial rewards (rebates, RPM and minimum pro…t) were
seen as an implicit compensation to the supermarket chains
for the exclusion of competing brands from their shelves
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VI. Competition (Antitrust) Policy
Vertically related markets

I Upstream …rms (suppliers) sell inputs to downstream …rms

(retailers)
I Double marginalization
I
retailer sells at a margin to the …nal consumers
I
supplier also sells at a margin to the retailer (if the is set price
per unit)
) ine¢ ciency: prices would fall and pro…ts would increase if they
merge or have non-linear contracts (for example, a two-part
tari¤)
I The real problems start when there are several …rms upstream
and/or downstream
I Can market power, say, upstream be transferred downstream?
I Resale price maintenance
I Exclusive dealing
I Chicago School: no!
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VII. R&D and Intellectual Property
What are the incentives for R&D?

I After the launch of the Xbox in 2005:

“It is surely no coincidence that Microsoft’s hidden ability
to innovate has become apparent only in a market in
which it is the underdog and faces …erce competition.
Microsoft is far less innovative in its core businesses, in
which it has a monopoly (in Windows) and a near
monopoly (in O¢ ce). But in the new markets of gaming,
mobile devices and television set-top boxes, Microsoft has
been unable to exploit its Windows monopoly other than
indirectly – it has …nanced the company’s expensive
forays into pasture new”

“The meaning of XBox”, The Economist, 24 November 2005

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VII. R&D and Intellectual Property
What are the incentives for R&D?

I Suppose protection of innovation is not an issue

I How does market structure a¤ect incentives to innovate?
I What are the incentives to innovate of the incumbent and the
entrant?
) How does innovation a¤ect market structure?
I Dynamic settings: R&D races
I How do the incentives to innovate compare to the socially
e¢ cient ones?

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VII. R&D and Intellectual Property
Intellectual Property

I Production of new knowledge or information faces the

problem of appropriability. It is driven by three main factors:
I Uncertainty (technological and commercial)
I Indivisibility
I The innovation cost of a new molecule in the pharmaceutical
industry is estimated to be e1.25 billion
I Very high specialization, economies of scale
I Marginal costs are way below average costs
I Public good nature
I Exclusion technologically is often not practical

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VII. R&D and Intellectual Property
Intellectual Property: Lego

I Lego was invented in the 1950s and patented, expired in 1978

I Since then, Lego has zealously guarded its trademarks and
other intellectual property
I For instance, it has …led dozens of lawsuits against competitors
such as Mega Bloks or Best-Lock
I Lego presented these e¤orts as a way to maintain a quality
product
I In the opinion of the competitors, Lego was rather using IP law
unfairly to extend its dominant position on the market
I Canadian Supreme Court (2005)
I “The monopoly on the bricks is over, and Mega Bloks and
Lego bricks may be interchangeable in the bins of the
playrooms of the nation. Dragons, castles and knights may be
designed with them, without any distinction”
I European Court of Justice (2010) ruled that the eight-peg
design of the original Lego brick "merely performs a technical
function Week
Industrial Organization, [and] cannot
1, Lecture 2 be registered as a trademark." 39 / 48
VII. R&D and Intellectual Property
Intellectual Property

I The main solution today: granting temporary monopoly right

I Patent: protects the idea for a short period of time
I Copyright: protects the form for a long period of time
I What is the optimal patent?
I The length and breadth

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VII. R&D and Intellectual Property
Intellectual Property: other ways to protect

I Trade secrets
I Coca-Cola recipe
I Prizes for a particular innovation
I Orteig Prize
I X Prize
I Longitude rewards

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VIII. Networks, Standards and Systems
Betamax vs. VHS

I Betamax (Sony): …rst-mover advantage, initial dominance

I Sony produced too much initially as a commitment to high
volume and low prices in the future
I Gradually, VHS (JVC) was getting popularity
I It o¤ered worse quality but longer recording times
I It was also cheaper
I JVC was licensing its technology to other producers
I Another way to commit to high volume and low prices in the
future

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VIII. Networks, Standards and Systems
Network e¤ects

I Each user’s utility is increasing in the number of other users of

that product or of products compatible with it
I Direct e¤ects: communication (language, messaging, etc.)
I Indirect: more options are available (consumer electronics,
operating systems, payment systems)
I In VCR market (Ohashi (2003 JEMS), Park (2004 Restat))
I the value of the network e¤ect grew from $5.6 million in 1978
to $343 million in 1986 for all US households (in constant
1978 US$)
I the network advantage of VHS explains at least 70.3% to
86.8% of (the logarithm of) relative sales of VHS to Betamax
in each year between 1981 and 1988

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VIII. Networks, Standards and Systems
Main issues

I Demand side: expectations matter and lead multiple

equilibria, “self-ful…lling prophecies”
I Provision of the network good: since users do not internalize
the positive externalities on others, there will too few of the
good provided
I Strategic choice of compatibility:
IBoth Sony and JVC had the option to adopt the other’s
standard very early on (before the introduction of the product
to the market)
I Compatibility lead to the competition in the market
I Incompatibility lead to the competition for the market

) War of standards and “winner-takes-all” outcome

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IX. Market Intermediation
Types of Intermediation

I Most products and services are not sold directly from the
producer to the …nal consumer but pass through intermediaries
I Four major roles/types of intermediaries:
1. Dealer: the intermediary buys goods or services from suppliers
and resells them to buyers
2. Platform operator: the intermediary provides a platform where
buyers and sellers (or more generally various groups of agents
with complementary businesses) are able to interact
3. Infomediary: the intermediary acts as an information
gatekeeper allowing consumers to access and process
information about prices or the match value of products and
services
4. Trusted third-party: the intermediary acts as a certi…cation
agent by revealing information about a product’s or seller’s
reliability or quality

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IX. Market Intermediation
What does Amazon do?

1. Amazon started in 1995 as a pure online dealer: …rst of

books, then of music CDs, videotapes, DVDs and software,
and later, of many other product categories
2. In 2001, inspired by eBay, Amazon launched its Marketplace
service that allows customers and third-party sellers to sell
books, CDs, DVDs, and other products (it also allows third
parties to set their own shop on Amazon). It became a
platform operator
3. Amazon also acted early on as infomediary by allowing users
to submit online product reviews and to rate products. It also
put in place a personal recommendation system
4. For other sellers on Amazon, Amazon plays the role of a
trusted third-party by organizing a reputation system:
consumers are invited to leave feedback on transactions
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IX. Market Intermediation
Dealers and platforms

I
Indirect network e¤ects: buyers bene…t from other buyers
because this attracts more sellers. Similarly for sellers.
I Heterogeneity is important
I Buyer and sellers self-select to participate given the prices of a
dealer
) Dealers can adjust the composition of either side
) The problems of adverse selection and search are diminished
I Platforms: charge access fees and transaction fees
I Payment systems (cards), video-game consoles, computer
operating systems, shopping malls, real-estate agents
I Singlehoming and multihoming
I In the beginning, most games were available for only one
console. Now, the usual case is that they are on all major
consoles
I What is better, dealer or platform?
I Apple’s iTunes Music Store vs. eBay
Industrial Organization, Week 1, Lecture 2 47 / 48
IX. Market Intermediation
Reputation on eBay

I Resnick et al. (2006 Exp Econ) conduct a controlled …eld

experiment
I An established seller o¤ers identical postcards under his name
and under a new name
I Buyers are willing to pay a premium to …rms with a longer
history, for comparable rates of favorable ratings
I In particular they …nd that consumers pay an 8% premium
when purchasing from a seller with 2000 positive feedbacks
and 1 negative instead of a seller with only 10 positive
feedbacks and no negatives.
I Cabral and Hortaçsu (2008 JIE) use panel data to …nd
I When a seller …rst receives negative feedback, his weekly sales
growth rate falls from plus 5% to minus 8%
I A seller is more likely to exit the lower his reputation. Just
before exiting sellers receive more negative responses than their
average: sellers “spend” their reputation
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