Industrial Part3

Ch.
7: Advertising
Chapter 7: Advertising
Industrial Organization • Search goods and experience goods
• Types of advertising
Universidad de Navarra • Optimal advertising expenditure
Academic year 2023-2024 • Advertising and welfare
Lecture slides – Chapter 7 • Advertising in two-sided markets
(updated 2023/8/18)
Industrial Organization – Chapter 7 1 Industrial Organization – Chapter 7 2
Search goods and experience goods
• Search goods
– User’s utility from consumption of the
Search goods and good can be anticipated before consuming
it
experience goods • Experience goods
– User’s utility from consumption of the
good can only be known after consuming it

Search goods and experience goods Search goods and experience goods
Which type of good is a table? Which type of good is a drink?
Search goods and experience goods Search goods and experience goods
Which type of good is an adventure park? Which type of good is a football game?

Search goods and experience goods
• Search goods
– User’s utility can be inferred by learning
about the characteristics of the good
• Experience goods Types of advertising
– Previous information about the product
characteristics tends to be of minor
relevance
Types of advertising According to the nature of the good
According to the nature of the good Informative advertising

• Informative advertising • Relevant for search goods
• Persuasive advertising • Informs about
– Existence of the good
• Advertising as signalling
– Characteristics
• Advertising as a complementary good – Prices
– Points of sale

According to the nature of the good According to the nature of the good
Informative advertising Persuasive advertising

• Relevant for experience goods
• Tries to persuade the consumer to
purchase the good
– Anticipate how (s)he may feel
– Emotions
Persuasive advertising Advertising as signalling

• Relevant for goods which quality
cannot be proven
• Advertising is perceived as a signal of
the quality of the good
• Related to “product differentiation”
when differentiation is subjective
Advertising as signalling Advertising as a complementary good

• Consuming some goods include an
“intangible”
– Something which is not related to the
features of the good but increases the
willingness to pay (prestige or
identification)
– This may be created through advertising
Advertising as a complementary good Advertising as a complementary good

According to the nature of the good Types of advertising
Advertising as a complementary good According to the competitive effect of
advertising
• Cooperative advertising
• Predatory advertising
According to the competitive According to the competitive

effect of advertising effect of advertising
Cooperative advertising • Cooperative advertising
• Advertising a brand increases the sales 𝝏𝝏𝒒𝒒𝒋𝒋
> 𝟎𝟎
of the other brands in the market 𝝏𝝏𝑨𝑨𝒊𝒊
• There is a market expansion effect • Perfectly cooperative advertising
𝝏𝝏𝒒𝒒𝒊𝒊 𝝏𝝏𝒒𝒒𝒋𝒋
=
𝝏𝝏𝑨𝑨𝒊𝒊 𝝏𝝏𝑨𝑨𝒊𝒊

Predatory advertising • Predatory advertising
• Advertising a brand decreases the sales 𝝏𝝏𝒒𝒒𝒋𝒋
< 𝟎𝟎
of the other brands in the market 𝝏𝝏𝑨𝑨𝒊𝒊
• Business stealing effect • Completely predatory advertising: market
size is constant
𝝏𝝏𝒒𝒒𝒊𝒊 𝝏𝝏𝒒𝒒𝒋𝒋
+ = 𝟎𝟎
𝝏𝝏𝑨𝑨𝒊𝒊 𝝏𝝏𝑨𝑨𝒊𝒊

Predatory advertising Predatory advertising
• The predatory effect of advertising leads • Table of firm’s expected profits
to a prisonner’s dilemma problem
• Advertising increases sales and requires
an advertising cost
• What’s the Nash equilibrium of this game?

• Best strategy for Firm 1 • Best strategy for Firm 1

• Best strategy for Firm 2 • Best strategy for Firm 2

• Nash equilibrium • Advertising in a market may become a
source of entry barrier to the market
• In a market where firms advertise a lot,
a new entrant is forced to spend in
advertising
• Advertising may be seen as an entry
cost which may prevent entry
Optimal advertising expenditure

• Dorfman-Steiner condition
– Rule to find the optimal level of advertising
– A firm’s demanded amount 𝑸𝑸 depends on
expenditure price 𝒑𝒑 and on the level of advertising 𝑨𝑨:
𝑸𝑸 = 𝑸𝑸 𝒑𝒑, 𝑨𝑨
– Firm’s problem:
𝒎𝒎𝒎𝒎𝒎𝒎𝑸𝑸,𝑨𝑨 𝝅𝝅 = 𝒑𝒑𝑸𝑸 − 𝑪𝑪 𝑸𝑸 − 𝑨𝑨
Optimal advertising expenditure Optimal advertising expenditure
First-order condition with respect to 𝑸𝑸: 𝒑𝒑 − 𝑴𝑴𝑪𝑪 𝝏𝝏𝒑𝒑 𝑸𝑸
=−
𝝏𝝏𝒑𝒑 𝝏𝝏𝑪𝑪 𝒑𝒑 𝝏𝝏𝑸𝑸 𝒑𝒑
𝑸𝑸 + 𝒑𝒑 − = 𝟎𝟎
𝝏𝝏𝑸𝑸 𝝏𝝏𝑸𝑸
𝒑𝒑 − 𝑴𝑴𝑪𝑪 𝟏𝟏
𝝏𝝏𝒑𝒑 𝑸𝑸 𝟏𝟏 𝝏𝝏𝑪𝑪 =
𝒑𝒑 𝝏𝝏𝑸𝑸 𝒑𝒑
+ 𝒑𝒑 − = 𝟎𝟎 −
𝝏𝝏𝑸𝑸 𝒑𝒑 𝒑𝒑 𝝏𝝏𝑸𝑸 𝝏𝝏𝒑𝒑 𝑸𝑸
𝝏𝝏𝒑𝒑 𝑸𝑸 𝒑𝒑 − 𝑴𝑴𝑪𝑪 𝒑𝒑 − 𝑴𝑴𝑪𝑪 𝟏𝟏

+ = 𝟎𝟎 =
𝝏𝝏𝑸𝑸 𝒑𝒑 𝒑𝒑 𝒑𝒑 𝜺𝜺

Where 𝜺𝜺 is the elasticity of demand in First-order condition with respect to 𝑨𝑨:
absolute value terms: 𝝏𝝏𝑸𝑸 𝝏𝝏𝑪𝑪
𝒑𝒑 − − 𝟏𝟏 = 𝟎𝟎
𝝏𝝏𝑨𝑨 𝝏𝝏𝑨𝑨
𝝏𝝏𝑸𝑸 𝒑𝒑
𝜺𝜺 = − 𝝏𝝏𝑸𝑸 𝝏𝝏𝑪𝑪 𝝏𝝏𝑸𝑸
𝝏𝝏𝒑𝒑 𝑸𝑸 𝒑𝒑 − − 𝟏𝟏 = 𝟎𝟎
𝝏𝝏𝑨𝑨 𝝏𝝏𝑸𝑸 𝝏𝝏𝑨𝑨
𝝏𝝏𝑸𝑸 𝒑𝒑
as < 𝟎𝟎 𝒑𝒑 −
𝝏𝝏𝑪𝑪 𝝏𝝏𝑸𝑸
− 𝟏𝟏 = 𝟎𝟎
𝝏𝝏𝒑𝒑 𝑸𝑸
𝝏𝝏𝑸𝑸 𝝏𝝏𝑨𝑨

𝝏𝝏𝑸𝑸 We notate as 𝝁𝝁 the elasticity of sales with respect to advertising:
𝒑𝒑 − 𝑴𝑴𝑪𝑪 = 𝟏𝟏
𝝏𝝏𝑨𝑨 𝝏𝝏𝑸𝑸 𝑨𝑨
𝝁𝝁 =
𝟏𝟏 𝝏𝝏𝑨𝑨 𝑸𝑸
𝒑𝒑 − 𝑴𝑴𝑪𝑪 = therefore:
𝝏𝝏𝑸𝑸 𝝏𝝏𝑸𝑸 𝑸𝑸
𝝏𝝏𝑨𝑨 = 𝝁𝝁
𝝏𝝏𝑨𝑨 𝑨𝑨
We can thus rewrite the previous equation as:
𝒑𝒑 − 𝑴𝑴𝑪𝑪 𝟏𝟏 𝒑𝒑 − 𝑴𝑴𝑪𝑪 𝟏𝟏 𝟏𝟏 𝟏𝟏 𝑨𝑨
=
𝒑𝒑 𝝏𝝏𝑸𝑸 𝒑𝒑
=
𝝏𝝏𝑸𝑸
= =
𝑸𝑸 𝝁𝝁 𝒑𝒑𝑸𝑸
𝒑𝒑 𝒑𝒑 𝒑𝒑𝝁𝝁
𝝏𝝏𝑨𝑨 𝝏𝝏𝑨𝑨 𝑨𝑨

Combining the two conditions: Rearranging terms, we get:
𝒑𝒑 − 𝑴𝑴𝑪𝑪 𝟏𝟏
𝒑𝒑
=
𝜺𝜺
𝑨𝑨 𝝁𝝁
=
𝒑𝒑𝑸𝑸 𝜺𝜺
𝒑𝒑 − 𝑴𝑴𝑪𝑪 𝟏𝟏 𝑨𝑨
𝒑𝒑
=
𝝁𝝁 𝒑𝒑𝑸𝑸 Dorfman-Steiner condition:
it yields: • The ratio of advertising to income is
𝟏𝟏 𝟏𝟏 𝑨𝑨 proportional to the elasticity of sales to
= advertising and inversely proportional
𝜺𝜺 𝝁𝝁 𝒑𝒑𝑸𝑸 to the elasticity of demand
Dorfman-Steiner condition:
Means that firms spend a higher
proportion of their sales’ income
Advertising and
• the more sensitive are sales to the welfare
advertising expenditure
• the more inelastic is firm’s demand
Advertising and welfare Advertising and welfare

There is a debate about whether Effect of advertising on competition:
advertising may increase or decrease • Informative advertising on prices
social welfare makes markets more competitive
There is not a clear answer, therefore • Persuasive advertising makes markets
we will discuss several facts regarding less competitive
this issue

Informative advertising on prices makes Persuasive advertising makes markets
markets more competitive less competitive
• More information on prices reduces the • Persuasive advertising increases the
search costs of consumers perception of consumers on product
• Consumers know the prices in different differentiation
stores more often and may visit the one • Consumers are ready to pay more for their
with lowest price most preferred variety
• Prices are thus reduced • Prices are thus higher

Model of Dixit and Norman Advertising a good has two effects
• Is there too much or too little • Increases the price of the good from 𝒑𝒑𝟏𝟏
advertising from the point of view of to 𝒑𝒑𝟐𝟐
social welfare? • Increases the volumen of sales from 𝒒𝒒𝟏𝟏
• Divergence between private and social to 𝒒𝒒𝟐𝟐
incentives to spend on advertising

Firms choose their optimal level of This implies too much advertising from the
advertising comparing the marginal cost point of view of social welfare: advertising
of advertising with the marginal revenue expenditure higher than the social optimal
• For firms,
– the increase is revenue is 𝒑𝒑𝟐𝟐 𝒒𝒒𝟐𝟐 − 𝒑𝒑𝟏𝟏 𝒒𝒒𝟏𝟏 But this analysis may not be totally correct if
• For society, advertising is a complementary good
– the increase is only 𝒑𝒑𝟐𝟐 𝒒𝒒𝟐𝟐 − 𝒒𝒒𝟏𝟏 (intangible), as initial consumers may obtain
– 𝒑𝒑𝟐𝟐 − 𝒑𝒑𝟏𝟏 𝒒𝒒𝟏𝟏 is a transfer from consumers to a value from consuming the advertised good
firms (transfer becomes lower than 𝒑𝒑𝟐𝟐 − 𝒑𝒑𝟏𝟏 𝒒𝒒𝟏𝟏 )
Advertising in two-sided markets
Let us consider a platform which

provides with advertising space to
Advertising in two- firms which are interested in
sided markets advertising their products to the
platform’s users

Advertising in two-sided markets Advertising in two-sided markets
Examples: Two-sided markets are characterised by

the existence of network effects between
SELLERS PLATFORM BUYERS the members of the different customer
NEWSPAPER/MAGAZINE READERS groups:
ADVERTISERS TV CHANNEL/EVENT SPECTATORS
INTERNET PORTAL VIEWERS • Positive network effects: the utility of
reaching the other group is higher the
higher the number of members of the group
• Negative network effects: the utility of
reaching the other group is lower the higher
the number of members of the group

Pricing strategies for platforms in two-sided In the case of advertising in platforms:
markets:
• Platforms don’t set a price for each group based • Network effects from buyers to sellers:
on the standard rule of marginal cost=marginal
income, as a lower price for one group may positive
increase the number of customers of that group • Network effects from sellers to buyers:
and thus the willingness to pay of the other
group may be positive (informative or
• Platforms tend to subsidise (set a price below complementary) or negative (nuisance)
cost) to the group which exerts a higher network
effect to the other group

Positive network effects from Negative network effects from

buyers to sellers: incentive for buyers to sellers: incentive for
platforms platforms
• Set low advertising prices • Set high advertising prices
• Attract many advertisers • Attract a few advertisers
Ch. 8: Price discrimination

Chapter 8: Price discrimination
Industrial Organization • Price discrimination practice
• Types of price discrimination
Universidad de Navarra • First-degree price discrimination
Academic year 2023-2024 • Second-degree price discrimination
Lecture slides – Chapter 8 • Third-degree price discrimination
• Intertemporal price discrimination
(updated 2023/8/18)

Price discrimination practice
Consists on charging different prices
according to the consumer or to the amount
Price discrimination purchased
Conditions for price discrimination:
practice • Consumers have different willingness to pay
• Resale is not allowed
• There must exist some degree of market power
or search costs (not perfect competition)
Types of price discrimination

According to the selection process:
• Selection based on indicators
Types of price • Self-selection
discrimination

Types of price discrimination Types of price discrimination
Selection based on indicators Self-selection
For example, the holders of some card The firm establishes different prices and
which requires conditions to obtain the consumer choses according to her/his
• Unemployed person willingness to pay
• Retired or elderlies • Prices for weekdays/weekends
• Student or under 16 – Movie theatres
• Big family member – Flight tickets (business and leisure)
Types of price discrimination Types of price discrimination

• Peak/off-peak (transport, utilities) Pigou’s classification:
• Release price (books, shows) • First-degree price discrimination
• Versioning: different prices for versions • Second-degree price discrimination
with different characteristics (extra • Third-degree price discrimination
features, advertising free)
• Sales: different prices at the beginning
and at the end of season
First-degree price discrimination
To charge a different price to each
individual consumer
First-degree price • When firms have perfect information
about the willingness to pay of each
discrimination single consumer, it will charge each
consumer a price equal to her/his
willingness to pay → perfect price
discrimination
First-degree price discrimination First-degree price discrimination
Perfect price discrimination Perfect price discrimination

• Leads to a socially efficient outcome Model of monopoly with
• There is no welfare loss • Demand function: 𝒑𝒑 = 𝒂𝒂 − 𝒃𝒃𝒃𝒃
• All the potential welfare is extracted by • Marginal cost: 𝒄𝒄
the firm
• Claim to forbid this practice: there is
efficiency but there is no equity
First-degree price discrimination First-degree price discrimination
Perfect price discrimination Perfect price discrimination

Firm’s profit: green area Consumer surplus = 0
𝑝𝑝 𝑝𝑝
𝑎𝑎 𝑎𝑎
𝑐𝑐 𝑐𝑐
𝑎𝑎−𝑐𝑐 𝑎𝑎 𝑎𝑎−𝑐𝑐 𝑎𝑎
𝑄𝑄 𝑏𝑏 𝑏𝑏
𝑄𝑄
𝑏𝑏 𝑏𝑏
Second-degree price discrimination
The price paid by a consumer depends

on the amount consumed
Second-degree price • Nonlinear pricing: when the price paid is
not proportional to the amount purchased
discrimination (example: flat rate)
• Two-part tariff: when there is a fixed rate
(for having access to the service) and a
variable rate (which depends on
consumption)
Second-degree price discrimination Second-degree price discrimination
Two-part tariff Two-part tariff

• Very frequent for utilities (water, • The variable rate not only affects the
electricity, natural gas) amount consumed
• The firm sets: • It also affects the subscription decision
(example: phone company without free
– Access fee calls) → an increase in the variable rate
– Variable rate decreases both the use and the number
of subscribers
Third-degree price discrimination
Set different prices for different

groups of consumers
Third-degree price • When first-degree price discrimination
discrimination is not allowed or when the firm knows
that there are different willingness to
pay but does not observe the
willingness to pay of each consumer

Third-degree price discrimination Third-degree price discrimination
• Spatial price discrimination: • Optimal pricing strategy: same marginal
– Different markets with different elasticity income (not price) for each market or
of demand group
– There must be some transport cost to
avoid arbitrage • The firm (weakly) increases profits as
• Price discrimination based on external one posible strategy is always to set the
indicators is third-degree price same price for each market/group
discrimination
Intertemporal price discrimination
All the previous analysis is based on

static (one-shot) frameworks:
Intertemporal price • The purchase and the consumption of
discrimination the good are simultaneous → this
happens for non-durable goods
• For durable goods, this is not
necessarily the case
Intertemporal price discrimination Intertemporal price discrimination
With durable goods: Let us present a model for durable goods

• Customers may buy in advance if they when we have two periods, 𝒕𝒕 = 𝟏𝟏, 𝟐𝟐:
expect the price to increase in the • Consumers willingness to pay in 𝒕𝒕 = 𝟏𝟏 is
future (Black Friday) uniformly distributed on the interval
𝟎𝟎, 𝟏𝟏𝟎𝟎𝟎𝟎
• Or may wait to buy later if they expect
• In 𝒕𝒕 = 𝟐𝟐, a consumer’s willingness to pay is
the price to decrease
half its willingness to pay in 𝒕𝒕 = 𝟏𝟏
The firm Example: 𝒑𝒑𝟏𝟏 = 𝟔𝟔𝟎𝟎

• Is a monopolist • Sales in 𝒕𝒕 = 𝟏𝟏: 𝒒𝒒𝟏𝟏 = 𝟏𝟏𝟎𝟎𝟎𝟎 − 𝟔𝟔𝟎𝟎 = 𝟒𝟒𝟎𝟎
• Decides the price in 𝒕𝒕 = 𝟏𝟏, 𝒑𝒑𝟏𝟏 , and the • Income in 𝒕𝒕 = 𝟏𝟏: 𝒑𝒑𝟏𝟏 𝒒𝒒𝟏𝟏 = 𝟔𝟔𝟎𝟎 × 𝟒𝟒𝟎𝟎 = 𝟐𝟐𝟒𝟒𝟎𝟎
price in 𝒕𝒕 = 𝟐𝟐, 𝒑𝒑𝟐𝟐 • Demand in 𝒕𝒕 = 𝟐𝟐: 𝒅𝒅𝟐𝟐 = 𝟐𝟐 𝟑𝟑𝟎𝟎 − 𝒑𝒑𝟐𝟐
• Has a demand function: • In order to obtain sales, the firm has to set
 𝒅𝒅𝟏𝟏 = 𝟏𝟏𝟎𝟎𝟎𝟎 − 𝒑𝒑𝟏𝟏 , in 𝒕𝒕 = 𝟏𝟏 a price in 𝒕𝒕 = 𝟐𝟐 of 𝒑𝒑𝟐𝟐 < 𝟑𝟑𝟎𝟎
𝒑𝒑𝟏𝟏
 𝒅𝒅𝟐𝟐 = 𝟐𝟐 − 𝒑𝒑𝟐𝟐 , in 𝒕𝒕 = 𝟐𝟐
𝟐𝟐

Case 1: the firm choses the price that Firm’s pricing schedule:
maximises the profit in 𝒕𝒕 = 𝟏𝟏 and keeps • 𝒑𝒑𝟏𝟏 = 𝟓𝟓𝟎𝟎, 𝒑𝒑𝟐𝟐 = 𝟓𝟓𝟎𝟎
that price in 𝒕𝒕 = 𝟐𝟐
Sales:
• Monopolist’s problem:
𝒎𝒎𝒂𝒂𝒎𝒎𝒑𝒑𝟏𝟏 𝝅𝝅𝟏𝟏 = 𝒑𝒑𝟏𝟏 𝒒𝒒𝟏𝟏 = 𝒑𝒑𝟏𝟏 𝟏𝟏𝟎𝟎𝟎𝟎 − 𝒑𝒑𝟏𝟏 • 𝒒𝒒𝟏𝟏 = 𝟓𝟓𝟎𝟎, 𝒒𝒒𝟐𝟐 = 𝟎𝟎 (as 𝒅𝒅𝟐𝟐 = 𝟐𝟐 𝟐𝟐𝟓𝟓 − 𝒑𝒑𝟐𝟐 )
• First-order condition: Firm’s profit:
𝝏𝝏𝝅𝝅𝟏𝟏 • 𝝅𝝅𝟏𝟏 = 𝟐𝟐𝟓𝟓𝟎𝟎𝟎𝟎, 𝝅𝝅𝟐𝟐 = 𝟎𝟎 → 𝝅𝝅 = 𝟐𝟐𝟓𝟓𝟎𝟎𝟎𝟎
= 𝟏𝟏𝟎𝟎𝟎𝟎 − 𝟐𝟐𝒑𝒑𝟏𝟏 = 𝟎𝟎
𝝏𝝏𝒑𝒑𝟏𝟏
Case 2: the firm choses the price that Monopolist’s problem in 𝒕𝒕 = 𝟐𝟐 becomes:
maximises the profit in 𝒕𝒕 = 𝟏𝟏 and 𝒎𝒎𝒂𝒂𝒎𝒎𝒑𝒑𝟐𝟐 𝝅𝝅𝟐𝟐 = 𝒑𝒑𝟐𝟐 𝟓𝟓𝟎𝟎 − 𝟐𝟐𝒑𝒑𝟐𝟐
changes the price in 𝒕𝒕 = 𝟐𝟐 to maximise 𝝏𝝏𝝅𝝅𝟐𝟐
the profit in 𝒕𝒕 = 𝟐𝟐 First-order condition: = 𝟓𝟓𝟎𝟎 − 𝟒𝟒𝒑𝒑𝟐𝟐 = 𝟎𝟎
𝝏𝝏𝒑𝒑𝟐𝟐
• Price in 𝒕𝒕 = 𝟏𝟏: 𝒑𝒑𝟏𝟏 = 𝟓𝟓𝟎𝟎 Solution: 𝒑𝒑𝟐𝟐 = 𝟏𝟏𝟐𝟐. 𝟓𝟓

• Monopolist’s problem in 𝒕𝒕 = 𝟐𝟐:
𝒎𝒎𝒂𝒂𝒎𝒎𝒑𝒑𝟐𝟐 𝝅𝝅𝟐𝟐 = 𝒑𝒑𝟐𝟐 𝒒𝒒𝟐𝟐 = 𝒑𝒑𝟐𝟐 × 𝟐𝟐 𝟐𝟐𝟓𝟓 − 𝒑𝒑𝟐𝟐

Firm’s pricing schedule: Case 3: the firm choses the price
• 𝒑𝒑𝟏𝟏 = 𝟓𝟓𝟎𝟎, 𝒑𝒑𝟐𝟐 = 𝟏𝟏𝟐𝟐. 𝟓𝟓 schedule of case 2 but consumers
Sales: anticipate the price decrease in 𝒕𝒕 = 𝟐𝟐
• 𝒒𝒒𝟏𝟏 = 𝟓𝟓𝟎𝟎, 𝒒𝒒𝟐𝟐 = 𝟐𝟐𝟓𝟓 • The consumer with willingness to pay of
Firm’s profit: 𝟓𝟓𝟎𝟎 obtains a surplus
• 𝝅𝝅𝟏𝟏 = 𝟐𝟐𝟓𝟓𝟎𝟎𝟎𝟎, 𝝅𝝅𝟐𝟐 = 𝟑𝟑𝟏𝟏𝟐𝟐. 𝟓𝟓 → 𝝅𝝅 = 𝟐𝟐𝟐𝟐𝟏𝟏𝟐𝟐. 𝟓𝟓  𝟎𝟎 if (s)he buys in 𝒕𝒕 = 𝟏𝟏
The monopolist gains a higher profit by  𝟏𝟏𝟐𝟐. 𝟓𝟓 if (s)he buys in 𝒕𝒕 = 𝟐𝟐
decreasing the price in the secondd period  (s)he buys in 𝒕𝒕 = 𝟐𝟐
With price schedule: 𝒑𝒑𝟏𝟏 = 𝟓𝟓𝟎𝟎, 𝒑𝒑𝟐𝟐 = 𝟏𝟏𝟐𝟐. 𝟓𝟓 Firm’s pricing schedule:
Let us find the sales in 𝒕𝒕 = 𝟏𝟏: • 𝒑𝒑𝟏𝟏 = 𝟓𝟓𝟎𝟎, 𝒑𝒑𝟐𝟐 = 𝟏𝟏𝟐𝟐. 𝟓𝟓
• Consumer which is indifferent between Sales:
buying at 𝒕𝒕 = 𝟏𝟏 or at 𝒕𝒕 = 𝟐𝟐 • 𝒒𝒒𝟏𝟏 = 𝟐𝟐𝟓𝟓, 𝒒𝒒𝟐𝟐 = 𝟓𝟓𝟎𝟎
• The one with willingness to pay 𝒗𝒗, s.t.: Firm’s profit:
𝒗𝒗
𝒗𝒗 − 𝟓𝟓𝟎𝟎 = − 𝟏𝟏𝟐𝟐. 𝟓𝟓 → 𝒗𝒗 = 𝟕𝟕𝟓𝟓 • 𝝅𝝅𝟏𝟏 = 𝟏𝟏𝟐𝟐𝟓𝟓𝟎𝟎, 𝝅𝝅𝟐𝟐 = 𝟔𝟔𝟐𝟐𝟓𝟓 → 𝝅𝝅 = 𝟏𝟏𝟐𝟐𝟕𝟕𝟓𝟓
𝟐𝟐

Firm’s profit is lower than in Case 1 The trust of consumers about the
• If consumers expect that the firm will commitment of the firm to keep prices in the
decrease its price in the future, some of future is key
them postpone their purchases and the • This is why some sellers announce that will
firm obtains a lower profit reimburse customers in the future if they
• The trust of consumers about the decrease prices (Chrysler did this)
commitment of the firm to keep prices in
the future is key
Coase’s conjecture • The monopolist’s market power is lower

• A monopolist selling a durable good the shorter the periods in which the
competes with itself across different monopolist may change its price
periods of time • In the limit, if the length of the period is
• The ability of the monopolist to change close to 𝟎𝟎, the profit of the monopolist will
prices in the future restricts the be 𝟎𝟎
monopolist’s market power

Sales • Consumers with higher willingness to pay buy

at the beginning of the season
• In some products (e.g. clothes), there is a • Consumers with lower willingness to pay wait
period of sales with a reduced price for the until the period of sales
units that have not been sold during the • The decision of waiting depends on:
– Consumer’s willingness to pay
season
– Consumer’s expectation about the existence of
• It’s another example of intertemporal the product (and size) in the period of sales
price discrimination – Consumer’s expectation about the share of
discount
Ch. 9: Entry and exit

Industrial Organization Chapter 9: Entry and exit
• Market entry and exit
• Barriers to entry, to exit and to mobility
Universidad de Navarra
Academic year 2023-2024
• Barriers to entry
Lecture slides – Chapter 9 • Entry deterrence
(updated 2023/11/21)

Market entry and exit
The standard model of perfect
competition assumes free entry and exit
Other assumptions:
Market entry and exit • Homogeneous product
• Perfect information: all buyers and sellers
have access at no cost to all relevant
information (costs, technology, prices…)
• Big number of sellers and buyers
Market entry and exit Market entry and exit

Implications: Perfectly competitive markets are
• Firms are price-acceptants difficult to find in real life as the four
• When firms have positive profits some firms conditions rarely hold simultaneously
will enter
• When firms have negative profits some firms
will exit
• Price is equal to marginal cost
• Firms’ profits are zero

Market entry and exit Market entry and exit
There is another type of markets which Assumptions:
do not need that degree of restriction in • Free entry and exit
assumptions: contestable markets • All firms have access to the same technology
(Beaumol, 1982) of production
• In contestable markets, the threat of • Perfect information on prices
entry from potential entrants limits • Firms may enter and exit before the installed
the market power of incumbents firms change their prices
(installed firms)
Market entry and exit

• Equilibrium price: sustainable price
– If price is higher than sustainable price, some
firms will enter
– If price is lower than sustainable price, some
Barriers to entry, to
firms will leave
• No need of a big number of firms to
exit and to mobility
reach a fairly competitive price
• No need to worry about monopolies if
market is contestable
Barriers to entry, exit and mobility Barriers to entry, exit and mobility
Barriers to entry: Problem with Stigler’s definition
• When there is an important degree of
• There are barriers to entry if, in the long economies of scale
run, installed firms may set prices above • Imagine a natural monopoly
marginal cost without attracting new • In the long run equilibrium, the monopolist is
entrants (Bain, 1968) very likely to charge a price above marginal cost
without attracting new entrants
• Barriers to entry are costs which must • If the incumbent and the potential entrants have
be incurred by new entrants but not by the same technology, there are entry barriers in
installed firms (Stigler, 1983) the sense of Bain, but not in the sense of Stigler
Barriers to entry, exit and mobility Barriers to entry, exit and mobility
Barriers to exit: Barriers to mobility:
• There are barriers to exit if an installed • Within a market, there are areas where entrants
are not necessarily new firms but may be firms
firm has to incur, directly or indirectly, in which are already active in other markets or
costs to exit the market areas
– E.g. close a mine (direct cost) • There are barriers to mobility when the
– E.g. a firm with assets which have not technology of a firm is specific of its area and
depreciated and are specific of that activity does not allow it to enter in a new area
→ opportunity cost (indirect cost) • These are barriers to entry in the sense of Stigler

Barriers to entry
Barriers to entry
• Legal barriers to entry
• Patents
Barriers to entry • Economies of scale
• Natural monopoly
• Monopoly regulation
• Imperfect information
Barriers to entry Barriers to entry

Legal barriers to entry Patents
• Sometimes, there are legal restrictions in • In order to foster innovation and research,
order to be allowed to enter the market the governments give a patent to the firm
• E.g. licences for drugstores or taxi drivers who develops a new product or process
• The aim of those restrictions is to guarantee • Transitory monopoly (typically, 20 years)
some quality of service or some minimum which allows the innovator to recover the
level of profits for incumbents investment which was required to obtain the
innovation

Advantages: Disadvantages:
• Incentivise research and development • Appropriation of commons: ideas which are
shared by different people but get owned
• Firms disclose their technology by the first one who claims them →
• Avoids duplication of research effort incentive to invest too many resources in
patent search
• Patent troll → when an invention needs the
use of previous invented items protected by
patents: obstruction, bargaining costs
Barriers to entry Economies of scale

• There is also a problem with the extent of the Economies of scale are represented by a
patent: decreasing average cost function
– The set of products or processes which a
protected by the patent 𝐴𝐴𝐴𝐴
– The way the extent of the patent is defined

affects significantly the level of protection and
the ability of new entry
– The extent is very often arbitrary
– E.g. razors with two razor blades or razors with
multiple razor blades 𝐴𝐴𝐴𝐴
𝑄𝑄
Economies of scale Economies of scale
But average cost functions are not unboundedly Minimum efficient scale (𝑴𝑴𝑴𝑴𝑴𝑴): the level of
decreasing, but there is typically some minimum value production (𝑸𝑸) at which 𝑨𝑨𝑨𝑨 reaches or approaches its
of 𝑨𝑨𝑨𝑨 minimum value
𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴
𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴
𝑄𝑄 𝑀𝑀𝑀𝑀𝑀𝑀 𝑄𝑄

Economies of scale act as a barrier to Related to the concept of economies of scale,
entry as a new firm, which would enter at we find the concepts of range economies and
a low scale of production, would be at experience advantages
disadvantage with respect to installed There are range economies when the cost of
firms and it may not be competitive as it jointly producing any two amounts 𝒒𝒒𝟏𝟏 and 𝒒𝒒𝟐𝟐
would have a higher average cost of of two goods is lower than the cost of
producing them separately:
production than the installed firms
𝑨𝑨 𝒒𝒒𝟏𝟏 , 𝒒𝒒𝟐𝟐 < 𝑨𝑨 𝒒𝒒𝟏𝟏 , 𝟎𝟎 + 𝑨𝑨 𝟎𝟎, 𝒒𝒒𝟐𝟐
The existence of range economies explain There are experience advantages when a
the proliferation of multiproduct firms firm′s payoff from being in the market
Some costs (transport, distribution, etc.) increases with past experience, measured by
are shared so the unit cost of each of them the number of periods it has previously been
is lower than for a singleproduct firm active (Cabral, 1994)
This implies a disadvantage for an entrant These advantages are due to market knowhow
and the trust and networking they have with
firm which would produce just one of the
customers, providers and the administration
goods

Natural monopoly Monopoly regulation
• A natural monopoly exists when the degree • Universal service: obligation to serve all the
of economies of scale is so important that the customers to avoid that the firm only serves
most efficient market structure is a monopoly the most profitable ones (postal service,
• Examples: the railway network, the piping of water, electricity)
water to households • Additionally, monopolies are often forced to
• To avoid exploitation of market power, they use uniform pricing: same prices to all
are often regulated customers (price discrimination not allowed)

Price regulation • Ceiling price
• Most efficient solution: – The government establishes a maximum price
– Price=marginal cost which the firm may charge
– Need of subsidising the firm to allow it to cover – As it is not related to cost, the firm has an
the fixed cost incentive to reduce the cost
• Price=average cost – Positive effect if the price reduction comes from
– No need to subsidise a more efficient innovation
– Lack of incentive for the firm to reduce costs, – Negative effect if the price reduction comes from
unless the price is fixed for a long period a lower quality of service provided

Imperfect information • Lack of relevant information for
• Imperfect information reduces the level of customers (information on quality)
entry and the number of firms in the – Consumers don’t trust in the quality
market claimed by the firm → lower willingness
• Lack of relevant information for firms to pay
(information on prices, costs, technology of – Adverse selection → only the products
production) → increases firms’ uncertainty with lower quality are eventuallt sold
and reduces the incentives to enter
Entry deterrence
Sometimes entry is deterred through
the strategies used by incumbent
firms who try to reduce the market
Entry deterrence and the profits of a potential
competitor
Entry deterrence Entry deterrence

Activities of entry deterrence • Foreclosure
• Limit pricing • Tying
• Predatory pricing • Bundling
• Capacity choice • Distribution
• Brand proliferation
• Advertising

Limit pricing Predatory pricing
• To set a price by an incumbent firm which is • To set a price below the marginal cost of
below the profit maximising price but production
above the competitive price in order to • The aim of this strategy is to avoid entry
avoid entry
• Once the threat of entry is over, the
• Such a price could be seen by a potential incumbent firm would increase prices
entrant as a signal of incumbent’s strength,
which could mean a low cost, a high • It’s forbidden by the competition
capacity, etc. authorities

Capacity choice Capacity choice: example
• Some firms strategically set a high capacity
of production so they can increase
production in case a new firm enters so it
can reduce its price
• Relevant if there are economies of scale
• If capacity is verifiable, it may act as a
signal for potential entrants

Brand proliferation Brand proliferation: example
• Relevant strategy when there is product
differentiation
• An incumbent firm produces a high
number of different brands in order to
avoid that a new firm enters the market
with a different product
• Example: ready-to-eat breakfast cereals

Advertising Foreclosure
• In some markets, firms massively advertise • Relevant when the incumbent is a
their products multiproduct firm which enjoys market
• A new entrant must expend a lot of money power in one of the markets
in advertising in order to be competitive • The firm uses the market power it has in
• Advertising becomes a relevant fixed entry one market to get market power in a
cost which may imply a barrier to entry different market

Tying Tying: example
• Sometimes the consumption of a good
requires the consumption of spare parts or
consumables
• Relevant issue: compatibility
• The incumbent has an incentive to make its
good incompatible with other firm’s
consumables so it can extend its market
power to the market for consumables

Tying: example Bundling
• Selling in a bundle two goods which could be
sold individually
• E.g.: a McDonald’s menu (burger, chips and
drink)
• There is a competitive concern when there is no
the possibility of buying each good alone
• Example: Microsoft with Windows 95 which
included Internet Explorer, sending Netscape out
of the market for navigators

Bundling: example Distribution
• Relevant for vertical markets, where
producers need agreements which sellers,
who sell a limited number of products:
supermarkets, tobacconists, bars and
restaurants
• Exclusive dealing: when the seller only sells
the products of one producer or group
Entry deterrence
Distribution: example
Industrial Organization
Universidad de Navarra
Academic year 2023-2024
Lecture slides – Chapter 10
(updated 2023/11/21)

Ch. 10: Mergers and vertical
relations
Chapter 10: Mergers and vertical relations
• Mergers and acquisitions
•
•
Types of mergers
Reasons for merging
Mergers and
•
•
Effects of mergers
Double-margin problem
acquisitions
• Horizontal mergers
• Vertical mergers
• Vertical relations in a market
Mergers and acquisitions Mergers and acquisitions

A merger takes place when two firms join • Before merging, each firm maximises its
together becoming one single firm individual profit
An acquisition takes place when one firm • After merging, the merged entity maximises
absorves another firm the joint profit
• From some legal or accounting aspects there • Two possibilities:
may be a difference – Each firm keeps its own brand and sells its
• For our goal of analysing the competitive effects, products (Nestlé)
the difference is not relevant – The merged entity operates under a single
• We will refer to any union of firms as a merger brand (Santander)
Mergers and acquisitions
• When modelling the market:
– Each firm keeps its own brand and sells its
products → 𝒎𝒎𝒎𝒎𝒎𝒎𝒒𝒒𝑨𝑨 ,𝒒𝒒𝑩𝑩 𝝅𝝅𝑨𝑨 + 𝝅𝝅𝑩𝑩
– The merged entity operates under a single Types of mergers
brand → 𝒎𝒎𝒎𝒎𝒎𝒎𝒒𝒒𝑨𝑨𝑩𝑩 𝝅𝝅𝑨𝑨𝑩𝑩
Types of mergers
Horizontal merger
• A union of firms which are in the same
market
Vertical merger
Reasons for
• A union of firms where one of them is
customer or provider of the other one merging
Conglomerate merger
• A union of firms which operate in unrelated
markets

Reasons for merging Reasons for merging
• Sinergies Sinergies
• Reduce competition • A merged entity may be more efficient
• Avoid the costs of entering a new as some activities are shared by the
market different products or brands (transport,
distribution, marketing) → range
• Risk diversification economies
• Avoid the double-marging problem

Reduce competition Avoid the costs of entering a new
• Relevant in horizontal mergers market
• The number of firms in the market is • A firm considering entry to a new
market may save the entry costs of
reduced as one of the firms is not your
advertising, marketing, dealing with
competitor any more local providers and customers if, instead
• Extreme case: merger to monopoly of entering with its brand, acquires a
(duopoly before the merger) local brand

Risk diversification Avoid the double-marging problem
• Usually the most important reason • Relevant for vertical markets
behind conglomerate mergers • When we have a producer and a
• The merged entity is a group with firms distributor, both firms seek profits
in different sectors or industries (maybe a double monopoly)
• If demand or cost conditions in a sector • If they merge the cost of the input for
worsen, the group may continue gaining the downstream firm is not the
profits in the other sectors monopoly price of the upstream firm
Effects of mergers
Effects of mergers
• Increased concentration
• Foreclosure
Effects of mergers • Costs
• Profits of merging firms
• Profits of non-merging firms
• Legal issues

Effects of mergers Effects of mergers
Increased concentration Foreclosure
• Specially relevant in vertical markets
• In horizontal mergers, the number of firms
• Imagine a vertical firm where an upstream firm
in the market is reduced possesses the network which needs to be used
• A lower number of firms increases prices by the downstream firms, which are the
providers of the service to the customer
• Unless the economies of scale are so • A merger between the upstream firm and one of
relevant that the decrease in costs the downstream firms gives incentives to the
compensates the effect of decreased merged entity to restrict access or charge high
competition access fee to the network to other downstream
providers

Examples: Costs
• Telefónica-Movistar • The merged entity may reduce costs due to
• AENA-Iberia, BAA-British Airways – Economies of scale
• ADIF-Renfe – Range economies
There are often regulations (obligation to give • These cost reductions increase efficiency
access, access fee…) to avoid abuses by the and may compensate the increase in prices
vertically integrated firm which results from increased concentration

Profits of merging firms Profits of non-merging firms
• The profits of the merging firms increase due • The non-merging firms increase their profits
to two reasons due to the effect of increased concentration
– Decreased competition • According to Stigler, the firms who gain the
– Decreased costs most with a merger are the non-merging
• The higher the cost reduction the higher the firms. True under some assumptions:
ability of the merged entity to undercut rivals – The merged entity sells one product instead of
and the more dominant it becomes, getting two
higher profits – The merged entity does not reduce costs

Legal issues Opposite view about mergers and
• When a group of firms plan to merge, they are concentration
obliged to report their intention to the • Structure-conduct-performance paradigm
competition authority who analyses the likely – More concentration → less competition → higher
effect of the merger and takes a decision: prices
– Block the merger – More ability to collude
– Allow the merger • Chicago school
– Allow the merger with conditions (sell some plants – Firms merging is an indicator of cost reduction →
or brands to a third firm) higher efficiency

Double-margin problem
Standard model: one stage
Double-margin FIRM
problem Market (price)
CONSUMER
Double-margin problem Double-margin problem

Vertical market: two stages Two firms looking for profits
PRODUCER • Interest for the producer
– Wide distribution
Upstream market (wholesale price)
– High wholesale price, which favors a high retail
price
DISTRIBUTOR
• Interest for the distributor
Downstream market (retail price)
– Low wholesale price
CONSUMER
– Market power in the downstream market

Double-margin problem Assumptions of the model:
• Arises in vertical markets with vertical • One producer (monopoly)
disintegration • Marginal cost: 𝑐𝑐
• As there are two firms seeking profits: • The only cost of the distributor is the
producer and distributor whosale price
• Causes an efficiency loss as it leads to higher Two cases
price and lower consumption than in the case • Vertical integration
of vertical integration • Vertical disintegration

Vertical integration: the cost of the input for Efficiency loss under vertical integration
the downstream firm is 𝒄𝒄 𝑝𝑝
𝑎𝑎
𝑝𝑝
𝑎𝑎
𝒎𝒎+𝒄𝒄
𝟐𝟐
𝒎𝒎+𝒄𝒄
𝟐𝟐
𝑐𝑐 𝑀𝑀𝑀𝑀
𝑀𝑀𝑀𝑀 𝐷𝐷
𝑀𝑀𝑀𝑀 𝐷𝐷
𝒎𝒎−𝒄𝒄 𝑎𝑎 𝑎𝑎
𝒎𝒎−𝒄𝒄 𝑎𝑎 𝑎𝑎 𝑄𝑄
𝑄𝑄 𝟐𝟐𝟐𝟐 2𝑏𝑏 𝑏𝑏
𝟐𝟐𝟐𝟐 2𝑏𝑏 𝑏𝑏

Vertical disintegration: the cost of the input for Efficiency loss under vertical disintegration
the downstream firm is 𝒎𝒎 (𝒎𝒎 > 𝒄𝒄) 𝑝𝑝
𝑝𝑝 𝑎𝑎
𝑎𝑎
𝑟𝑟
𝑟𝑟
𝑚𝑚
𝑚𝑚
𝑀𝑀𝑀𝑀 𝐷𝐷 𝑀𝑀𝑀𝑀 𝐷𝐷
𝑎𝑎 𝑎𝑎 𝐷𝐷𝑀𝑀 𝑎𝑎 𝑎𝑎
𝑄𝑄 𝐷𝐷𝑀𝑀
2𝑏𝑏 𝑏𝑏
𝑄𝑄 𝑄𝑄 2𝑏𝑏 𝑏𝑏
𝑄𝑄
Horizontal mergers
As we have seen, a horizontal merger
• Increases concentration and market power in
the market
Horizontal mergers • Increases the profit of the merging firms
• Increases the profits of the non-merging
firms

Horizontal mergers Horizontal mergers
• According to Stigler the firm which earns We’ll use two models of horizontal
most is the one which doesn’t merge mergers to analyse this discussion
• But this may not be the case if the merged Two cases
entity reduces its cost of production due to
the existence of economies of scale and/or 1. Products are homogeneous
range economies – We use Cournot-type competition
• Also the picture may be different when there 2. Products are differentiated
is product differentiation – We use Hotelling-type competition

1. Analysis of merger between two firms – The demand function is 𝒑𝒑 = 𝒎𝒎 − 𝟐𝟐𝒃𝒃
with product homogeneity – Each firm has a marginal cost equal to 𝒄𝒄
– There are three firms in the industry: 𝟏𝟏, 𝟐𝟐 – The marginal cost of the merged firm is 𝒄𝒄𝒄
and 𝟑𝟑
– Firms 𝟏𝟏 and 𝟐𝟐 merge
– As the products of both firms are identical,
there’s no point in producing both goods
after merger
Market pre-merger: – First-order condition for firm 𝟏𝟏:
𝝏𝝏𝝅𝝅𝟏𝟏
– Three firms: 𝟏𝟏, 𝟐𝟐 and 𝟑𝟑 = 𝒎𝒎 − 𝟐𝟐𝟐𝟐𝒒𝒒𝟏𝟏 − 𝟐𝟐𝒒𝒒𝟐𝟐 − 𝟐𝟐𝒒𝒒𝟑𝟑 − 𝒄𝒄 = 𝟎𝟎
𝝏𝝏𝒒𝒒𝟏𝟏
– Demand: 𝒑𝒑 = 𝒎𝒎 − 𝟐𝟐 𝒒𝒒𝟏𝟏 + 𝒒𝒒𝟐𝟐 + 𝒒𝒒𝟑𝟑
– Symmetry condition: 𝒒𝒒𝟏𝟏 = 𝒒𝒒𝟐𝟐 = 𝒒𝒒𝟑𝟑
– Profit functions: – Equation becomes:
• 𝝅𝝅𝟏𝟏 = 𝒑𝒑 − 𝒄𝒄 𝒒𝒒𝟏𝟏 = 𝒎𝒎 − 𝟐𝟐 𝒒𝒒𝟏𝟏 + 𝒒𝒒𝟐𝟐 + 𝒒𝒒𝟑𝟑 − 𝒄𝒄 𝒒𝒒𝟏𝟏 𝒎𝒎−𝒄𝒄
𝒎𝒎 − 𝟒𝟒𝟐𝟐𝒒𝒒𝟏𝟏 − 𝒄𝒄 = 𝟎𝟎 → 𝒒𝒒𝟏𝟏 =
• 𝝅𝝅𝟐𝟐 = 𝒑𝒑 − 𝒄𝒄 𝒒𝒒𝟐𝟐 = 𝒎𝒎 − 𝟐𝟐 𝒒𝒒𝟏𝟏 + 𝒒𝒒𝟐𝟐 + 𝒒𝒒𝟑𝟑 − 𝒄𝒄 𝒒𝒒𝟐𝟐 𝟒𝟒𝟐𝟐
𝒎𝒎−𝒄𝒄
• 𝝅𝝅𝟑𝟑 = 𝒑𝒑 − 𝒄𝒄 𝒒𝒒𝟑𝟑 = 𝒎𝒎 − 𝟐𝟐 𝒒𝒒𝟏𝟏 + 𝒒𝒒𝟐𝟐 + 𝒒𝒒𝟑𝟑 − 𝒄𝒄 𝒒𝒒𝟑𝟑 – Outputs: 𝒒𝒒𝟏𝟏 = 𝒒𝒒𝟐𝟐 = 𝒒𝒒𝟑𝟑 =
𝟒𝟒𝟐𝟐
𝒎𝒎+𝟑𝟑𝒄𝒄
– Price: 𝒑𝒑 =
𝟒𝟒

𝒎𝒎−𝒄𝒄 𝟐𝟐 Market post-merger:
– Profits: 𝝅𝝅𝟏𝟏 = 𝝅𝝅𝟐𝟐 = 𝝅𝝅𝟑𝟑 =
𝟏𝟏𝟏𝟏𝟐𝟐
𝒎𝒎−𝒄𝒄 𝟐𝟐
– Two firms: 𝟏𝟏𝟐𝟐 and 𝟑𝟑
– Joint profit of firms 𝟏𝟏 and 𝟐𝟐: 𝝅𝝅𝟏𝟏 + 𝝅𝝅𝟐𝟐 = – Demand: 𝒑𝒑 = 𝒎𝒎 − 𝟐𝟐 𝒒𝒒𝟏𝟏𝟐𝟐 + 𝒒𝒒𝟑𝟑
𝟖𝟖𝟐𝟐
𝒎𝒎−𝒄𝒄 𝟐𝟐
– Profit of firm 𝟑𝟑: 𝝅𝝅𝟑𝟑 = – Profit functions:
𝟏𝟏𝟏𝟏𝟐𝟐
𝟗𝟗 𝒎𝒎−𝒄𝒄 𝟐𝟐 • 𝝅𝝅𝟏𝟏𝟐𝟐 = 𝒑𝒑 − 𝒄𝒄𝒄 𝒒𝒒𝟏𝟏𝟐𝟐 = 𝒎𝒎 − 𝟐𝟐 𝒒𝒒𝟏𝟏𝟐𝟐 + 𝒒𝒒𝟑𝟑 − 𝒄𝒄𝒄 𝒒𝒒𝟏𝟏𝟐𝟐
– Consumer surplus: 𝑪𝑪𝑪𝑪 = • 𝝅𝝅𝟑𝟑 = 𝒑𝒑 − 𝒄𝒄 𝒒𝒒𝟑𝟑 = 𝒎𝒎 − 𝟐𝟐 𝒒𝒒𝟏𝟏𝟐𝟐 + 𝒒𝒒𝟑𝟑 − 𝒄𝒄 𝒒𝒒𝟑𝟑
𝟑𝟑𝟐𝟐𝟐𝟐
𝟏𝟏𝟏𝟏 𝒎𝒎−𝒄𝒄 𝟐𝟐
– Social welfare: 𝑾𝑾 =
𝟑𝟑𝟐𝟐𝟐𝟐

– First-order condition for firm 𝟏𝟏𝟐𝟐: – Profit of the merged firm: 𝝅𝝅𝟏𝟏𝟐𝟐 =
𝒎𝒎+𝒄𝒄−𝟐𝟐𝒄𝒄𝟐 𝟐𝟐
𝝏𝝏𝝅𝝅𝟏𝟏𝟐𝟐 𝟗𝟗𝟐𝟐
= 𝒎𝒎 − 𝟐𝟐𝟐𝟐𝒒𝒒𝟏𝟏𝟐𝟐 − 𝟐𝟐𝒒𝒒𝟑𝟑 − 𝒄𝒄𝒄 = 𝟎𝟎 – Profit of firm 𝟑𝟑: 𝝅𝝅𝟑𝟑 =
𝒎𝒎+𝒄𝒄𝟐−𝟐𝟐𝒄𝒄 𝟐𝟐
𝝏𝝏𝒒𝒒𝟏𝟏𝟐𝟐 𝟗𝟗𝟐𝟐
– First-order condition for firm 𝟑𝟑:
𝝏𝝏𝝅𝝅𝟑𝟑
= 𝒎𝒎 − 𝟐𝟐𝒒𝒒𝟏𝟏𝟐𝟐 − 𝟐𝟐𝟐𝟐𝒒𝒒𝟑𝟑 − 𝒄𝒄 = 𝟎𝟎
𝝏𝝏𝒒𝒒𝟑𝟑
𝒎𝒎+𝒄𝒄−𝟐𝟐𝒄𝒄𝟐 𝒎𝒎+𝒄𝒄𝟐−𝟐𝟐𝒄𝒄
– Outputs: 𝒒𝒒𝟏𝟏𝟐𝟐 = , 𝒒𝒒𝟑𝟑 =
𝟑𝟑𝟐𝟐 𝟑𝟑𝟐𝟐
𝒎𝒎+𝒄𝒄+𝒄𝒄𝟐
𝟑𝟑

Let us analyse the case of no cost reduction by Effect on welfare:
the merged firm → 𝒄𝒄 = 𝒄𝒄𝒄: 𝟐𝟐 𝒎𝒎−𝒄𝒄 𝟐𝟐
𝒎𝒎−𝒄𝒄 𝟐𝟐 𝒎𝒎−𝒄𝒄 𝟐𝟐 – Consumer surplus: 𝑪𝑪𝑪𝑪 =
– 𝝅𝝅𝟏𝟏𝟐𝟐 = , 𝝅𝝅𝟑𝟑 = 𝟗𝟗𝟐𝟐
𝟗𝟗𝟐𝟐 𝟗𝟗𝟐𝟐 𝟒𝟒 𝒎𝒎−𝒄𝒄 𝟐𝟐
Previous to merger: – Social welfare: 𝑾𝑾 =
𝟗𝟗𝟐𝟐
𝒎𝒎−𝒄𝒄 𝟐𝟐 𝒎𝒎−𝒄𝒄 𝟐𝟐 Previous to merger:
– 𝝅𝝅𝟏𝟏 + 𝝅𝝅𝟐𝟐 = , 𝝅𝝅𝟑𝟑 =
𝟖𝟖𝟐𝟐 𝟏𝟏𝟏𝟏𝟐𝟐 𝟗𝟗 𝒎𝒎−𝒄𝒄 𝟐𝟐 𝟏𝟏𝟏𝟏 𝒎𝒎−𝒄𝒄 𝟐𝟐
– So, if there’s no cost advantage, the merged – 𝑪𝑪𝑪𝑪 = , 𝑾𝑾 =
𝟑𝟑𝟐𝟐𝟐𝟐 𝟑𝟑𝟐𝟐𝟐𝟐
firm decreases profit and the non-merging The merger decreases consumer and social
firm’s profit increases significantly surplus
Competition authorities are very reluctant to According to Stigler, there must be some
accept mergers as their view is still rooted on advantage as firms will only desire to merge if
the structure-conduct-performance paradigm they increase profits:
which predicts higher prices and lower welfare 𝒎𝒎 + 𝒄𝒄 − 𝟐𝟐𝒄𝒄𝒄 𝟐𝟐 𝒎𝒎 − 𝒄𝒄 𝟐𝟐
as a consequence of mergers 𝝅𝝅𝟏𝟏𝟐𝟐 = > 𝝅𝝅𝟏𝟏 + 𝝅𝝅𝟐𝟐 =
𝟗𝟗𝟐𝟐 𝟖𝟖𝟐𝟐
But the Chicago School trusts more in the cost Therefore 𝒄𝒄𝒄 will be significantly lower than 𝒄𝒄
advantages of mergers And the net effect on social welfare is very
likely to be positive

2. Analysis of merger between two firms – Each firm 𝒊𝒊 sells one single product and
with product differentiation chooses its price 𝒑𝒑𝒊𝒊 and its location 𝒎𝒎𝒊𝒊 in a
two-stage game
– We use Hotelling-type competition
• Stage 1: firms simultaneously choose locations
– Let us consider a market with three firms: • Stage 2: firms simultaneously set prices
𝟏𝟏, 𝟐𝟐 and 𝟑𝟑 – Transportation costs for consumers are
– Consumers are uniformly distributed in a quadratic, so the utility of a consumer located
linear market of length = 𝟏𝟏 at 𝒎𝒎 when buying from firm 𝒊𝒊 is:
𝟐𝟐
𝒖𝒖 𝒎𝒎 = 𝒗𝒗 − 𝒑𝒑𝒊𝒊 − 𝒎𝒎 − 𝒎𝒎𝒊𝒊
𝟐𝟐
𝒖𝒖 𝒎𝒎 = 𝒗𝒗 − 𝒑𝒑𝒊𝒊 − 𝒎𝒎 − 𝒎𝒎𝒊𝒊 Let us assume that the firms are ordered in the
where following way:
• 𝒗𝒗 is the reservation price (identical for all
consumers) 0 𝑥𝑥1 𝑥𝑥2 𝑥𝑥3 1
• 𝒎𝒎 − 𝒎𝒎𝒊𝒊 𝟐𝟐 is the transport cost of the A change in a firm’s location has two effects:
consumer
• Market share effect
• 𝒎𝒎 − 𝒎𝒎𝒊𝒊 is the absolute value of the distance
between the consumer and the firm’s • Price effect
location

There is a tradeoff:
0 𝑥𝑥1 𝑥𝑥2 𝑥𝑥3 1 • Market share effect
For firm 𝟑𝟑: – Incentivises firms to locate close to other firms
• The closer to firm 𝟐𝟐 (𝒎𝒎 = 𝒎𝒎𝟐𝟐 ), the higher its – Leads to agglomeration
sales (market share effect) • Price effect
• The closer to the right end (𝒎𝒎 = 𝟏𝟏), the – Incentivises firms to locate far from other firms
higher its price, as there’s a higher degree of – Leads to dispersion
differentiation (price effect)
Equilibrium pre-merger Let us consider a merger between firms 𝟏𝟏
• Reported in Brenner (2005): and 𝟐𝟐
• 𝒎𝒎𝟏𝟏 = 𝟎𝟎. 𝟏𝟏𝟐𝟐𝟏𝟏, 𝒎𝒎𝟐𝟐 = 𝟎𝟎. 𝟏𝟏, 𝒎𝒎𝟑𝟑 = 𝟎𝟎. 𝟖𝟖𝟖𝟖𝟏𝟏 • The merged firm now maximises its joint
• 𝒑𝒑𝟏𝟏 = 𝟎𝟎. 𝟐𝟐𝟎𝟎𝟑𝟑, 𝒑𝒑𝟐𝟐 = 𝟎𝟎. 𝟏𝟏𝟖𝟖𝟐𝟐, 𝒑𝒑𝟑𝟑 = 𝟎𝟎. 𝟐𝟐𝟎𝟎𝟑𝟑 profit
• 𝒒𝒒𝟏𝟏 = 𝟎𝟎. 𝟐𝟐𝟖𝟖𝟎𝟎𝟖𝟖, 𝒒𝒒𝟐𝟐 = 𝟎𝟎. 𝟒𝟒𝟏𝟏𝟖𝟖𝟑𝟑, 𝒒𝒒𝟑𝟑 = 𝟎𝟎. 𝟐𝟐𝟖𝟖𝟎𝟎𝟖𝟖 Two possibilities:
• 𝝅𝝅𝟏𝟏 = 𝟎𝟎. 𝟎𝟎𝟏𝟏𝟏𝟏, 𝝅𝝅𝟐𝟐 = 𝟎𝟎. 𝟎𝟎𝟖𝟖𝟖𝟖𝟖𝟖, 𝝅𝝅𝟑𝟑 = 𝟎𝟎. 𝟎𝟎𝟏𝟏𝟏𝟏 1. Firms maintain the same locations and only
• Joint profit of firms 𝟏𝟏 and 𝟐𝟐: 𝝅𝝅𝟏𝟏 + 𝝅𝝅𝟐𝟐 = adapt prices
𝟎𝟎. 𝟏𝟏𝟑𝟑𝟖𝟖𝟖𝟖
2. Firms adapt both prices and locations

Equilibrium post-merger with fixed locations Equilibrium post-merger with changed
• Reported in Elizalde (2012): locations
• 𝒎𝒎𝟏𝟏 = 𝟎𝟎. 𝟏𝟏𝟐𝟐𝟏𝟏, 𝒎𝒎𝟐𝟐 = 𝟎𝟎. 𝟏𝟏, 𝒎𝒎𝟑𝟑 = 𝟎𝟎. 𝟖𝟖𝟖𝟖𝟏𝟏 • Reported in Elizalde (2012):
• 𝒑𝒑𝟏𝟏 = 𝟎𝟎. 𝟏𝟏𝟑𝟑𝟗𝟗, 𝒑𝒑𝟐𝟐 = 𝟎𝟎. 𝟒𝟒𝟐𝟐𝟐𝟐, 𝒑𝒑𝟑𝟑 = 𝟎𝟎. 𝟑𝟑𝟐𝟐𝟖𝟖 • 𝒎𝒎𝟏𝟏 = 𝟎𝟎, 𝒎𝒎𝟐𝟐 = 𝟎𝟎, 𝒎𝒎𝟑𝟑 = 𝟏𝟏
• 𝒒𝒒𝟏𝟏 = 𝟎𝟎. 𝟏𝟏𝟏𝟏𝟏𝟏𝟑𝟑, 𝒒𝒒𝟐𝟐 = 𝟎𝟎. 𝟒𝟒𝟎𝟎𝟏𝟏𝟑𝟑, 𝒒𝒒𝟑𝟑 = 𝟎𝟎. 𝟒𝟒𝟑𝟑𝟖𝟖𝟏𝟏 • 𝒑𝒑𝟏𝟏 = 𝟏𝟏, 𝒑𝒑𝟐𝟐 = 𝟏𝟏, 𝒑𝒑𝟑𝟑 = 𝟏𝟏
• 𝝅𝝅𝟏𝟏 = 𝟎𝟎. 𝟎𝟎𝟖𝟖𝟒𝟒𝟐𝟐, 𝝅𝝅𝟐𝟐 = 𝟎𝟎. 𝟏𝟏𝟖𝟖𝟏𝟏𝟒𝟒, 𝝅𝝅𝟑𝟑 = 𝟎𝟎. 𝟏𝟏𝟒𝟒𝟑𝟑𝟏𝟏 • 𝒒𝒒𝟏𝟏 = 𝟎𝟎. 𝟐𝟐𝟏𝟏, 𝒒𝒒𝟐𝟐 = 𝟎𝟎. 𝟐𝟐𝟏𝟏, 𝒒𝒒𝟑𝟑 = 𝟎𝟎. 𝟏𝟏
• Joint profit of firms 𝟏𝟏 and 𝟐𝟐: 𝝅𝝅𝟏𝟏 + 𝝅𝝅𝟐𝟐 = 𝟎𝟎. 𝟐𝟐𝟏𝟏𝟏𝟏𝟏𝟏 • 𝝅𝝅𝟏𝟏 = 𝟎𝟎. 𝟐𝟐𝟏𝟏, 𝝅𝝅𝟐𝟐 = 𝟎𝟎. 𝟐𝟐𝟏𝟏, 𝝅𝝅𝟑𝟑 = 𝟎𝟎. 𝟏𝟏
• Joint profit of firms 𝟏𝟏 and 𝟐𝟐: 𝝅𝝅𝟏𝟏 + 𝝅𝝅𝟐𝟐 = 𝟎𝟎. 𝟏𝟏

Horizontal mergers
In a horizontal merger with differentiated
products the merged firms increase their
profits significantly even in the absence of
economics of scale Vertical mergers
Vertical mergers Vertical mergers

Let us consider a vertical market with the • Demand in the downstream market
following features 𝒑𝒑 = 𝟏𝟏 − 𝒒𝒒𝟏𝟏 − 𝒒𝒒𝟐𝟐
• Upstream market • Input prices in the downstream market
– Firms 𝑨𝑨 and 𝑩𝑩 – Input price for firm 𝟏𝟏: 𝒄𝒄𝟏𝟏
– Compete in a Bertrand fashion – Input price for firm 𝟐𝟐: 𝒄𝒄𝟐𝟐
• Downstream market • Profit functions in the downstream market
– Firms 𝟏𝟏 and 𝟐𝟐 𝝅𝝅𝟏𝟏 = 𝟏𝟏 − 𝒒𝒒𝟏𝟏 − 𝒒𝒒𝟐𝟐 𝒒𝒒𝟏𝟏 − 𝒄𝒄𝟏𝟏 𝒒𝒒𝟏𝟏
– Compete in a Cournot fashion 𝝅𝝅𝟐𝟐 = 𝟏𝟏 − 𝒒𝒒𝟏𝟏 − 𝒒𝒒𝟐𝟐 𝒒𝒒𝟐𝟐 − 𝒄𝒄𝟐𝟐 𝒒𝒒𝟐𝟐

• Solutions • Case 1: vertical disintegration
𝟏𝟏−𝟐𝟐𝒄𝒄𝟏𝟏 +𝒄𝒄𝟐𝟐 𝟏𝟏−𝟐𝟐𝒄𝒄𝟐𝟐 +𝒄𝒄𝟏𝟏 – As the upstream firms (𝑨𝑨 and 𝑩𝑩) compete in a
– Outputs: 𝒒𝒒𝟏𝟏 = , 𝒒𝒒𝟐𝟐 =
𝟑𝟑 𝟑𝟑 Bertrand fashion, Bertrand competition leads to
𝒎𝒎+𝒄𝒄𝟏𝟏 +𝒄𝒄𝟐𝟐 upstream prices 𝒄𝒄𝟏𝟏 = 𝒄𝒄𝟐𝟐 = 𝟎𝟎
𝟑𝟑 – Downstream firms’ quantities and price:
𝟏𝟏 𝟏𝟏
𝒒𝒒𝟏𝟏 = 𝒒𝒒𝟐𝟐 = , 𝒑𝒑 =
𝟑𝟑 𝟑𝟑
– Firms’ profits:
𝟏𝟏
𝝅𝝅𝑨𝑨 = 𝝅𝝅𝑩𝑩 = 𝟎𝟎, 𝝅𝝅𝟏𝟏 = 𝝅𝝅𝟐𝟐 =
𝟗𝟗

• Case 2: vertical merger between 𝑨𝑨 and 𝟏𝟏 – Downstream firms’ quantities and price:
– Firms 𝑨𝑨 and 𝟏𝟏 are integrated, so firm 𝟏𝟏 uses the 𝟏𝟏 𝟏𝟏 𝟏𝟏
product of firm 𝑨𝑨 at price 𝒄𝒄𝟏𝟏 = 𝟎𝟎
𝒒𝒒𝟏𝟏 = , 𝒒𝒒𝟐𝟐 = , 𝒑𝒑 =
𝟏𝟏𝟐𝟐 𝟏𝟏 𝟏𝟏𝟐𝟐
– Firm 𝑩𝑩 now provides firm 𝟐𝟐 at price 𝒄𝒄𝟐𝟐 – Firms’ profits:
– Quantities in the downstream market are: 𝟐𝟐𝟏𝟏 𝟏𝟏 𝟏𝟏
𝝅𝝅𝑨𝑨𝟏𝟏 = , 𝝅𝝅𝑩𝑩 = , 𝝅𝝅𝟐𝟐 =
𝟏𝟏+𝒄𝒄𝟐𝟐 𝟏𝟏−𝟐𝟐𝒄𝒄𝟐𝟐 𝟏𝟏𝟒𝟒𝟒𝟒 𝟐𝟐𝟒𝟒 𝟑𝟑𝟏𝟏
𝒒𝒒𝟏𝟏 = , 𝒒𝒒𝟐𝟐 = In this example the integrated firm increases
𝟑𝟑 𝟑𝟑
– Upstream market: As firm 𝑩𝑩 no longer competes profits, whereas the upstream non-merging
with firm 𝑨𝑨, it charges the price which maximises its
𝟏𝟏 firm increases profit and the downstream one
profit: 𝒄𝒄𝟐𝟐 = decreases profits
𝟒𝟒

Vertical mergers
In this example the upstream firms were
Bertrand competitors charging zero prices pre-
merger
– But this is rarely observed in reality
Vertical relations in
– Vertical mergers tend to be more easily
allowed by competition authorities than
a market
horizontal mergers as the efficiency gain is
more obvious, as it avoids the double-
margin problem
Vertical relations in a market Vertical relations in a market

Different incentives in vertical markets Contracts in vertical markets
• Interest for the producer • Exclusive dealing: the distributor cannot sell
– Wide distribution the product of other producers
– High wholesale price, which favors a high retail • Licensing: the producer allows the distributor
price to sell its product, often under exclusivity
• Interest for the distributor The type of contract signed depends on the
– Low wholesale price bargaining power of each firm, which typically
– Market power in the downstream market depends on its market power
Vertical relations in a market Vertical relations in a market
Licensing: Resale price maintenance
• Advantages • The price is set by the producer
– Limits competition in downstream market • Allowed in books, magazines, newspapers
– High price in downstream market which favors a and pharmaceuticals
high price in upstream market
• Fobidden for most goods as it limits price
– More control of the quality of the service competition
• Disadvantage
– Lower distribution → possibility of bottleneck
Vertical relations in a market

Buyer power
• Equivalent to market power, but referred to
buying instead of selling
• When sales of upstream firms are concentrated
in a few firms, the latter will have a high degree
of bargaining power, limiting the market power
of the upstream firms (e.g. Mercadona)
Monopsony
• Market structure with one single buyer
Industrial Organization – Chapter 10 76

Industrial Part3

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Industrial Part3

Uploaded by

Copyright:

Available Formats

Ch.

Industrial Organization – Chapter 7 1 Industrial Organization – Chapter 7 2

Search goods and experience goods

Industrial Organization – Chapter 7 3 Industrial Organization – Chapter 7 4

Which type of good is a table? Which type of good is a drink?

Industrial Organization – Chapter 7 5 Industrial Organization – Chapter 7 6

Industrial Organization – Chapter 7 7 Industrial Organization – Chapter 7 8

Industrial Organization – Chapter 7 9 Industrial Organization – Chapter 7 10

Types of advertising According to the nature of the good

According to the nature of the good Informative advertising

Industrial Organization – Chapter 7 11 Industrial Organization – Chapter 7 12

Informative advertising Persuasive advertising

Industrial Organization – Chapter 7 13 Industrial Organization – Chapter 7 14

Persuasive advertising Advertising as signalling

Advertising as signalling Advertising as a complementary good

Advertising as a complementary good Advertising as a complementary good

Industrial Organization – Chapter 7 19 Industrial Organization – Chapter 7 20

Industrial Organization – Chapter 7 21 Industrial Organization – Chapter 7 22

According to the competitive According to the competitive

Industrial Organization – Chapter 7 23 Industrial Organization – Chapter 7 24

Industrial Organization – Chapter 7 25 Industrial Organization – Chapter 7 26

According to the competitive According to the competitive

• What’s the Nash equilibrium of this game?

Industrial Organization – Chapter 7 27 Industrial Organization – Chapter 7 28

Industrial Organization – Chapter 7 29 Industrial Organization – Chapter 7 30

According to the competitive According to the competitive

Industrial Organization – Chapter 7 31 Industrial Organization – Chapter 7 32

Optimal advertising expenditure

𝝏𝝏𝒑𝒑 𝑸𝑸 𝒑𝒑 − 𝑴𝑴𝑪𝑪 𝒑𝒑 − 𝑴𝑴𝑪𝑪 𝟏𝟏

Optimal advertising expenditure Optimal advertising expenditure

Industrial Organization – Chapter 7 39 Industrial Organization – Chapter 7 40

Optimal advertising expenditure Optimal advertising expenditure

Industrial Organization – Chapter 7 45 Industrial Organization – Chapter 7 46

Advertising and welfare Advertising and welfare

Industrial Organization – Chapter 7 47 Industrial Organization – Chapter 7 48

Industrial Organization – Chapter 7 49 Industrial Organization – Chapter 7 50

Advertising and welfare Advertising and welfare

Industrial Organization – Chapter 7 51 Industrial Organization – Chapter 7 52

Advertising in two-sided markets

Let us consider a platform which

Industrial Organization – Chapter 7 55 Industrial Organization – Chapter 7 56

Examples: Two-sided markets are characterised by

Advertising in two-sided markets Advertising in two-sided markets

Industrial Organization – Chapter 7 59 Industrial Organization – Chapter 7 60

Positive network effects from Negative network effects from

Industrial Organization – Chapter 7 61 Industrial Organization – Chapter 7 62

Ch. 8: Price discrimination

Industrial Organization – Chapter 8 1 Industrial Organization – Chapter 8 2

Industrial Organization – Chapter 8 3 Industrial Organization – Chapter 8 4

Types of price discrimination

Industrial Organization – Chapter 8 5 Industrial Organization – Chapter 8 6

Industrial Organization – Chapter 8 7 Industrial Organization – Chapter 8 8

Types of price discrimination Types of price discrimination

First-degree price discrimination First-degree price discrimination

Perfect price discrimination Perfect price discrimination

Perfect price discrimination Perfect price discrimination

Second-degree price discrimination

The price paid by a consumer depends

Two-part tariff Two-part tariff

Third-degree price discrimination

Set different prices for different

Industrial Organization – Chapter 8 21 Industrial Organization – Chapter 8 22