Industrial Organization Analysis: Review questions

1) Define and discuss the terms “horizontal product differentiation” and “vertical product differentiation”.
Discuss how product differentiation influences market structure and firms’ market power.
a. Horizontal product differentiation:
i. Consumers value characteristics differently.
b. Vertical product differentiation:
i. All consumers agree on the value of different characteristics.
c. Influence on market structure and market power:
i. The greater the degree of product differentiation, the greater the degree of market
power.
ii. If price competition is very intense, then firms tend to locate far apart (high degree of
differentiation). If price competition is not very intense, then firms tend to locate close
to each other (low degree of differentiation).

2) Discuss and exemplify the “characteristics approach” to product differentiation. For which type of
products is the characteristics approach a good way to illustrate product differentiation, and for which
types is it not?
a. The characteristics approach estimates demand of a good based on demand for each
characteristic of a good (the price of these implicit characteristic is referred to as hedonic
prices). I.e. A product is valued by the value of each characteristic instead of as a whole.
i. The more complex the products, the more relevant the characteristics approach
becomes and vice versa.

3) Discuss the relation between market size and the number of firms in the market.
a. Due to increased price competition, the equilibrium number of active firms varies less than
proportionally with respect to market size.

4) Define “exogenous sunk (entry) costs” and “endogenous sunk (entry) costs”. With reference to a market
that is growing over time, explain how the number of firms is expected to change over time.
a. Exogenous sunk (entry) costs:
 i. Fixed entry costs. E.g. license, taxi medallion
b. Endogenous sunk (entry) costs:
i. Costs incurring while entering in order to survive. E.g. R&D, advertising
c. Number of firms:
i. If entry costs are endogenous, then the number of firms is less sensitive to changes in
market size.

5) Define a “free entry equilibrium”. Discuss whether a free entry equilibrium has too few or too many firms,
relative to the number that would maximize total welfare.
a. Free entry equilibrium:
i. Entry/exit is free, and 1) no active firm wishes to leave the market and 2) no inactive
firm wishes to enter the market.
b. Total welfare:
i. Total welfare is optimized in an equilibrium under perfect competition as prices are at
their lowest and some firms still profit (most efficient ones).

6) Assume that there is one incumbent firm and one potential entrant. The incumbent firm announces that
it will start a price war if the entrant would decide to come into the market. Discuss whether the
incumbent’s threat to start a price war should influence the entrant’s decision to enter the market or not.
a. If the thread is credible it should influence the potential entrant’s decision to enter. The
incumbent firm is likely to have efficient production and can stay profitable at a lower price than
the entrant. Also; sequential game, sub-game Nash equilibrium.

7) Discuss the “merger paradox”.

a. The fact that in a homogenous, symmetric industry with Firms competing à la Cournot these
firms have no incentive to merge.
b. Solutions to merger paradox:
i. If the merged firm can gain a leadership position in the industry, a merger might be
profitable.
 ii. If the firms have differentiated products which are either complements or substitutes
and compete in prices they might gain by internalizing complementary effects or
business stealing effects.
iii. If the firms manage to reduce their costs due to the merger, they may have an incentive
to merge.

8) Discuss whether one should expect firms competing in the same market to have similar market shares.
Discuss some factors that might give rise to an uneven distribution of market shares.
a. The more similar the firms and the more homogenous the market, the more similar market
shares. It is rare that firms are entirely symmetric and markets are completely homogenous,
thus market share often depends on product differentiation and efficiency.

9) Discuss whether one should expect to find a relationship between market concentration and a) the
profitability of individual firms b) the total profits of all firms in the market?
a. Structure-performance hypothesis: Positive correlation between concentration and market
power. With high market power comes high profits.
b. Positive correlation between market concentration and total profits of all firms, as competition
is less intense with high concentration.

10) Explain and discuss the “direct effect” and the “strategic effect” for product location decisions.
a. Direct effect: An increase in quality corresponds to a change in profits that takes place if prices
remain constant at their initial equilibrium level.
b. Strategic effect: The equilibrium price adjustments following a change in product quality.

11) Explain how market power can be measured and define in regard to this the Lerner index.
a. Market power can be measured by natural generalization of the margin of a firm. The Lerner
Index measures this as the weighted average of each firm’s margin, with weights given by the
firm’s market share.

12) Assume that an upstream firm is selling to one or more downstream firms, which in turn are selling to
final customers. Downstream firms decide on both the price to the final customers and the service level
 to provide. Discuss why and how the service level choices might be distorted, relative to what an
integrated firm would choose. Discuss some vertical restraints (or contracts) that might limit the
distortions.
a. Upstream firms have an incentive to set high prices in order to receive great margins, although if
service is essential for end-users then receiving lower margins for upstream firms, would
incentivize downstream firms greater to offer service as they would still make profits.

13) Discuss the relation between market structure and market power.
a. The greater the concentration, the greater the market power. E.g. monopoly = high power,
perfect competition = low power.

14) The airfares between New York and Tokyo are interesting. There are nine airlines. The six with the lowest
price all charge $1134 in economy class and $2350 for ‘business class’. Is this evidence of (implicit or
explicit) collusion?
a. A number of industry characteristics, provide stronger evidence that it is implicit/tacit collusion:
i. Perfect information, homogenous products,

15) When is it possible for firms to tacitly collude? Give some industry characteristics which tend to make
tacit collusion more likely to be successful. Tacit collusion is typically not a violation of competition laws
but explicit collusion is typically illegal in every industrialized country. It is a fact that sometimes firms are
found guilty of explicit collusion – why didn’t they collude tacitly instead?
a. Perfect information makes tacit collusion a possibility.
b. Industry characteristics:
i. Concentrated markets
ii. Symmetric firms / symmetric incentives
iii. Multi market contact firms
iv. Institutional factor
v. Homogenous products
vi. Industries with high growth rate
vii. Industries that are likely to survive
viii. Low turnover
c. Communication is the main difference between tacit and explicit collusion. Say there isn’t
perfect information in a market, then firms aren’t able to collude unless communicating.
16) “The degree of monopoly power is limited by the elasticity of demand." Discuss how one can measure
monopoly power. Exemplify.
a. One can measure market (monopoly) power by setting market concentration relative to
elasticity. The higher the elasticity, the less power a firm actually has.

17) Explain the Bertrand paradox. How can we explain empirical observations on profits given the Bertrand
paradox?
a. The Bertrand paradox concerns the fact that a firm has high incentive to undercut the other as it
will gain the entire market, but as the other firm knows the two firms will undercut each other
until MC = P.
b. Ways to avoid the Bertrand Paradox:
i. Product differentiation
ii. Dynamic competition
iii. Asymmetric costs
iv. Capacity constraints

18) Price wars imply losses for all of the firms. Can it then be rational for a firm to start a price war?
a. It can be rational if want they want to drive out competitors (predatory pricing), as a thread to
potential entrants, or if they want to obtain learnings by having a first-mover advantage, which
in turn will make the firm more efficient.
b. If price cuts are difficult to observe, then occasional price wars may be necessary to discipline
collusive agreements.

19) Discuss differences between endogenous and exogenous sunk cost industries.
a. Endogenous industries are characterized by ongoing innovation, R&D and advertising in order to
capture market demand, whereas exogenous industries have certain predefined costs that are
transparent and doesn’t vary much.
20) Explain why it is unlikely that the relation between market size and the number of firms is linear.
a. Due to increased price competition, the equilibrium number of active firms varies less than
proportionally with respect to market size.
i. As the number of firms increases, the market becomes more competitive, that is, the
margin decreases. As a result, variable profit per unit of market size also decreases,
which in turn limits the number of firms the market can sustain.

21) Discuss whether, theoretically, one should expect a relationship between market share and profitability.
a. Theoretically, high market share indicates high market power, which in turn correlates with high
margins and profitability. Note: market power is limited by elasticity.