Economics of industry

Economics of industry The economic consequences of market power, the foundations of industrial policies industrypartsa/b

Intro • The economic consequences of the size/ scope of firms, of the structure of markets, of the existence and exercise of market power. • The economic consequences of the firm’s search for, use and protection of market power. • The S-C-P (mainstream textbook) view of the world, some alternative views, evidence and interpretations. • A deliberately critical evaluation. Economics is about learning how to think not what to think. industrypartsa/b

References etc • For outline/ suggested textbook/ and references see class guide. Remember I am not following the textbook closely. The textbook is complementary not a substitute. It has a lot more detail than I can present in the lectures. It should be pretty obvious where to look for extra details in the textbook for the issues as they arise so only from time to time will I refer specifically to the textbook. • NB there are some supplementary word based notes ( one on market power, one on oligopoly etc) as well as the lecture slides on the web pages. industrypartsa/b

L&W text Chap 1.2 (views of competition), • 2.5/ 2.6 (basics of case for competition), • 10.3 (price discrimination and significance), • 14.2 (Arrow model and innovation) • and 17.2 and 18.2 (more on basic case against m power) industrypartsa/b

Parts • A. The problem outlined: the monopoly model, monopoly power, and economic efficiency • B. The debate started: examining the foundations of the mon. model • C. The debate continued: beyond monopoly. Oligopoly models, cooperative and non-cooperative, and what these tell us about the consequences of market power • D. The evidence considered: statistical evidence on the effects of market power and the interpretation of the evidence • E. Other aspects: consequences re vertical integration/ M&As discussed later industrypartsa/b

Economic consequences of firm s/e/p market power ? • For firm’s profits (private interest) • For economic efficiency broadly defined (social/ public interest) • And the idea of a ‘social welfare loss’ from monopoly and oligopoly (m power). • Including consequences of actions such as vertical restraints and M&As? industrypartsa/b

Watch the words • What firm’s are actually seeking for is economic profit or economic added value (EVA) but mainstream texts on IO focus exclusively on market power as the means to achieving this end so it is these means which they investigate and condemn. Other possible sources of success, such as entrepreneurial insight, innovation, or superior organisation qualities, aren’t even considered. Firms don’t succeed because they are good at what they do but because they acquire and exploit ‘market power’. • As we will argue later this is both strange and questionable. It seems to assume something about the determinants of business performance, of the sources of business profit, rather than treating this as an issue to be investigated. industrypartsa/b

Focus issues • How satisfactory is the economic case against market/ monopoly power as a foundation for public policy actions against dominant firms, collusion, mergers, etc. In particular how good is the evidence. • Contrasting two schools of thought: the mainstream Harvard SCP school and its Chicago school critics. • Leads us to a consideration of competition policy itself. industrypartsa/b

Competition policy • ‘In this report comp policy is used as a convenient term to cover the policy on monopolies/ mergers/restrictive practices/resale price maintenance/ and other ‘uncompetitive practices’. The criterion for action …is the public interest … defined in terms of industrial efficiency’ • Government ‘Review of Monopoly and Merger Policy’, 1978 • This tells us what C policy is about and its underlying objectives. industrypartsa/b

Com Pol is an element of wider government involvement in the economy called ‘industrial policy’ which is concerned in principle with state efforts to improve overall economic performance by, it is hoped, making the economy more dynamic and efficient. • Gov cannot do this directly, by dictation, so it has to approach it indirectly by acting on the business environment (promoting competition) and on the actions of firms seeking market power. industrypartsa/b

Assumption • On which policy rests is that there is a direct and significant link between (market) Structure-(firm) Conduct and (market) Performance (efficiency). Hence ‘SCP’ school. The theoretical basis being the Harvard school of industrial economics as developed by Bain, Caves, Porter et al. • But these views are not universally accepted. Some, more sceptical, economists believe there is no really satisfactory verifiable basis for c policy, that it could end up doing more harm than good. industrypartsa/b

Some minority views • There is also a (perhaps extreme) minority view (liberalism) which promotes competition as an end in itself, not just as a means to industrial efficiency. This would promote more competition even if this damaged industrial efficiency (eg Charles Rowley). Belief is that dispersed economic power is vital to democracy and personal responsibility and thus is opposed ‘big business’ power in principle. • At other extreme are those who think monopoly is fine as long as it is socialised and publicly owned. Belief here is that m is ok if it seeks the ‘public interest’ rather than profit. Once official UK labour party policy. The labour party has usually been perfectly happy to promote public monopoly whilst attacking private monopoly as exploitative. In fact a lot of competition policy in this country has been developed under labour governments. industrypartsa/b

Part A: The problem outlined • Problem with which c policy seeks to deal is the ‘presumed’ socially detrimental consequences of a firm or a group of firms seeking and using market power. • The detriments are believed to arise as a result of economic efficiency losses which theory suggests are associated with market power and the (damaging) efforts of powerful firms as they seek to extend/ exploit/maintain their power. The problem has two aspects: • 1. The monopoly or dominant firm problem • 2. The collusion or restrictive practices problem (cooperative cartels/ collusive tendering) sometimes referred to as a ‘complex monopoly’. industrypartsa/b

The case against m power and for more competition • Is that in general it harms economic efficiency, broadly defined, compared to competitive structures (we take knowledge of the competitive model as given here). • The case against covers: allocative effic, organisational effic, and dynamic efficiency (and some other complaints such as ‘wasteful’ advertising). industrypartsa/b

NB • The case against market power is developed from a comparison of two simple extremes (pc and m). The implication being that if monopoly is ‘bad’ and (p) competition is ‘optimal’ anything increasing market power is suspect and anything that increases competition is good. • Thus is it that in some countries ‘monopoly’ is often thought to become a problem when a dominant firm has 25/30% of a relevant market. We will see later under oligopoly theory that what happens in between the extreme models is much more complicated than that. industrypartsa/b

Allocative efficiency • The key argument in theory. The traditional simple textbook comparison of ‘good’ competition against ‘bad’ monopoly. Under a long list of strictly defined conditions (to be examined later) we get: • P > MC, • Lower output produced, (compared to pc) • Private super-normal profits (which is the incentive), and • There arises a net or ‘deadweight’ loss of social welfare measured in terms of consumer surplus and called the Harberger triangle. See diag for details of these effects. industrypartsa/b

Harberger triangle? • After Arnold Harberger, a Chicago economist. • Who in fact was critical of mainstream m theory and developed his famous triangle idea as a tool for identifying and estimating the size of the ‘harm’ from monopoly. We discuss later, under evidence, his initial finding which was that these losses were in fact rather trivial! And of course the many follow up studies which have supported or sought to challenge this initial finding. • This is how economics works: idea, challenge, response, improved understanding. industrypartsa/b

Monopoly and alloc. efficiency • Diagram one (at lecture) industrypartsa/b

Organisational efficiency • Idea here is that the absence of competitive pressures causes employees to slacken off their pursuit of cost efficiency. Thus employees indulge in effort relaxation, excessive expenses, big offices, lots of personal assistants, etc. • Which causes overall firm cost levels to rise and exacerbates the impact of market power. • Redraw diagram one and allow for higher level of costs, check outcome. How much worse is it? • Commonly called ‘X’ efficiency after Leibenstein (Harvard) who coined the term industrypartsa/b

Organisational effic • Diagram two industrypartsa/b

But • Owners/ managers can in principle invest in greater effort to control organisational inefficiency and keep costs under control. Monitoring and enforcement efforts. Carrots like bonuses, sticks like foremen/ supervisors. • But to the extent that these extra efforts cost more than under comp conditions then these costs can be seen as a resource ‘waste’ of monopoly. So even if a monopolist ‘looks’ reasonably efficient there may still be harmful consequences because of the extra efforts needed to achieve this outcome. • Competition is being seen here as a cheaper device for generating discipline and promoting organisational efficiency. industrypartsa/b

Dynamic efficiency (innovation) • It is argued that competition not only forces firms to be cost ‘efficient’, it also forces them to be innovative, to be dynamically eff, if they wish to maintain their competitiveness or to escape from the pressures of comp markets and earn some ‘above normal’ profits. • Under mon it is argued that the incentive to innovate is inevitably reduced. The mon already earns nice profits and this implies a naturally lesser incentive to innovate. (The profits of innovation less current profits basically). But NB the mon still has an incentive to innovate. industrypartsa/b

Arrow’s model • There is an influential simple formal model which purportedly demonstrates this (intuitive?) result, called the Arrow model (after Kenneth Arrow). It is in the textbook (eg George) along with the long debate it ignited. • The model is arguably a bit naïve (even George says it ‘strains credulity’) because it examines only the motivation of comp firms to adopt a new idea (rather than to seek it out in the first place) and so ignores the issue of the ability to undertake investment in R&D and innovation. Which may be even more important. We examine the issue more fully later on. • NB I say arguably naïve, in view of the fact that Arrow won his Nobel prize for ideas like this! Respect! industrypartsa/b

A paradox? • Also, is there a paradox or a puzzle here? • Competition creates incentives for innovation (so it is argued) often because it offers the prospect of monopoly profits! ie it offers an escape from competition. But if mon is harmful, couldn’t the competitive incentive to seek one be seen as harmful or wasteful? (see the Posner bit later) industrypartsa/b

Monopoly and product quality • Argument (*more advanced*) that monopoly will tend to harm product quality, since firm has less incentive to promote the socially optimal level of product quality. • Quality choice for the profit seeking monopolist will lead to an outcome where marginal cost of improving quality is equated with the marginal revenue from the provision of higher quality. • As long as producing better quality is privately profitable it gets produced. But …. industrypartsa/b

Never mind the quality.. • But it is argued that the production of quality by the mon will be socially sub optimal. The socially optimal level of quality is at the point where the marginal social cost of producing quality equals the social marginal benefit of quality (as measured by willingness to pay, or price) which would be chosen say by a ‘benign’ ‘socialist’ monopolist (who exists in the textbook only). • What is not clear however is whether private profit seeking competitive firms will produce the optimal quality outcome either. industrypartsa/b

Quality diagram • Diagram 3 Value of increases in quality Quality industrypartsa/b

Quality range • It is argued further that a comp market will encourage a full range of quality, say from cheery but cheap at the bottom to exquisite but expensive at the top as competitive firms seek to fill the available market space. • Whilst the monopoly will not provide a full range of offerings. It will produce enough at the top of the range but not at the bottom. The logic is it will seek to push more consumers ‘up market’ and thus wish to reduce the possibility of consumers buying at the lower end. industrypartsa/b

Is this suspicious? • If a ‘comp’ firm fills each quality space available wouldn’t it then have a monopoly for producing that quality of product? Paradox? • Textbooks use airlines for example, arguing that the difference between 1st class, and no class is an example of the issue. But how would competition (or a benign monopolist) work here? A first class flight only, a second class, and so on? industrypartsa/b

Posner’s extension • Richard Posner argues that since monopoly is valuable competing firms will invest resources in searching for monopoly situations. (Also called rent seeking in some texts). Indeed you could say that competition is often the search for monopoly. • Thus firms may invest in efforts to encourage gov to regulate competition (in airlines or banking), to restrict imports, to provide lengthy patent rights, • And invest in R&D, advertising, acquire competitors, etc to win and maintain m power. industrypartsa/b

Posner cont. • How much will firms invest in the search for mp? • Posner argues that firms will invest (in total) as much as the expected (capitalised) mon profits! (It’s a bit like a lottery game) • Hence he suggests that this competition to become the monopolist is potentially just as socially ‘wasteful’ as having a monopoly so that the ‘costs’ of monopoly are arguably much greater than Harberger had originally suggested. It is Harberger triangle plus the private profit rectangle now. industrypartsa/b

Posner cont. • Why? Because although the winner appropriates some nice juicy profits after paying of its costs, if you net out the costs to society of the various efforts that everyone else put in to winning then overall we are no better off in total! And the efforts are measured by the expected profits of winning. industrypartsa/b

Why like a lottery? • Cause in total we all subscribe a lot more to the lottery than in total we can expect to win back! • In fact each week we (in total) get back in prizes only half of what we pay for the tickets we buy! • In this sense competition to win big prizes leads us to considerably oversubscribe (or over-invest) cause we rate our own chances of winning too highly (we behave irrationally). And this is potentially ‘inefficient’ or wasteful socially with respect to say R&D competition. industrypartsa/b

But this suggests that competition is the problem not monopoly and where does this logic lead? Publicly owned monopolies perhaps (the old LSE/ labour view)? • It is indeed possible sometimes to see competition in a not so benign light. For example choice can be nice but it can become confusing not to say overwhelming. Been to Comet to buy a TV recently? Indeed competition can be a nuisance sometimes. Buses clogging the streets. Crowded airports. Double glazing salesmen phoning you. Newspapers with more adverts than news. TV advertising. Who needs it? • Or might it be poss to distinguish ‘good’ (socially beneficial) competitive efforts from the not so good? industrypartsa/b

Good v bad competition? • Eg advertising is a comp weapon. If adv provides us with useful information it is valuable (efficient) socially but if it is mostly persuasive (encouraging brand jumping a la Coke/Pepsi) or builds entry barriers it is arguably not so good socially. Gets a bit difficult however. • Who is to judge what is useful info and what is ‘harmful’ persuasion? Maybe we enjoy being persuaded? And herein lies scope for quite different interpretations of the relation between market profitability and firm behaviour. The mainstream ‘harmful’ view that any above competitive level profits is due to ‘m power’, and the more benign competitive advantage view that it is due to superior capabilities and competencies to be considered later. industrypartsa/b

Posner’s analogy • Is along the lines that the true economic cost of crime is not measured by the goods stolen but include the cost of resources devoted to crime and its prevention. Which may be reasonable. • But the analogy of efforts to beat the competition with criminal activity may be less reasonable. To say that efforts to build a brand or to innovate are anti-social in the way that bank robbery is seems to be stretching it a bit. Even lobbyists are not necessarily anti-social. There is such a thing as unfair foreign competition or unfair infringements of property rights and it is legitimate to complain about them. industrypartsa/b

Call that a case? • So that’s the essence of the ‘harmful’ case. Question is, how good a case is it? Is it as strong as mainstream textbooks suggest? How good is the empirical and case evidence on these things? Is there another more benign way of looking at firm behaviour and ‘excess’ profits? • This is what we seek to consider next. industrypartsa/b

Part B. Debating the foundations • A closer look at the foundations/ assumptions of the mainstream view (see any standard chapter on monopoly model). Aim here is to show that the standard results depend on a number of arguably extreme and possibly questionable assumptions. • NB not aiming here to show m power is actually good for us, simply to suggest that it is not so easy to demonstrate convincingly that it is harmful in practice. • Assumptions (1,2,…10) examined in turn. industrypartsa/b

1. Only one firm in the market • Therefore no possibility of rivalry, no interdependence, of any sort. Firm is a price maker pure and simple. • Because once any rivalry exists (as oligopoly or even fringe competition) the results get harder to predict as we see later. But one result is for sure: the social ‘harm’ of m power declines depending on the precise characteristics of the oligopoly in question. A key issue becomes the possibility of sustainable collusion which as we will see later is harder than it seems. • NB also: empirically speaking absolute 100% mon is not common, except when granted by the state! Dominance is more common (big businesses with substantial m shares, say 50+ %) but that’s a different game! industrypartsa/b

2. No ‘close’ substitutes • For the monopolists product/ service. • Because if there are, the (harmful) power to raise prices above marginal costs diminishes. • The availability of subs affects the position and elasticity of the market demand function. And elasticity is a crucial determinant of the ‘harmfulness’ of monopoly result. It enters into calculations of the size of the Harberger triangle (see evidence part). • For example there is only one Euro-tunnel but the subs (ferries, planes) seem to be close enough to constrain it quite effectively. In fact it loses lots of money! And so do some of the substitutes! industrypartsa/b

Elasticity of demand: significance • Recall the definition and significance from earlier classes. And the precise relation between elasticity and total and marginal revenue. NB also the profit seeking monopolist always prices where elasticity exceed one. Why? • Note that since the m price is where demand is ‘elastic’ there must be substitutes available to produce that result. • Note also how the size of elasticity (e) (2,3,4,5) determines the exact divergence of monopoly price from cost. • Look up the ‘Lerner index’ which formally expresses this relationship. As e increases the price-cost margin falls. industrypartsa/b

Substitutes and containers • Lets say there was one firm producing all the glass bottles, one producing plastic, one doing aluminium cans, one doing tetra pak cartons etc. Does this mean four ‘harmful’ monopolies or a differentiated competitive oligopoly market? • Are Coca Cola and Pepsi monopolists or do they produce very close substitutes? What about CC and Perrier? Or CC and coffee? • Point is, it is a matter of degree. Ultimately everything is competing with everything else for the consumer’s dollars (and other resources). Drawing neat boundaries and calling them ‘markets’ is more difficult than it appears. What is the software market? The drinks market? • Although identifying industry bounds is easier cause this is defined in terms of production technology (glass bottles and aluminium cans) not competing substitutes. industrypartsa/b

Monopolistic competition • In fact the so called mon comp model is often construed as harmful as well. This is a model with all the characteristics of perfect comp apart from homogeneous products. It allows for the existence of slightly varied or differentiated products which are very close, but not perfect, substitutes. So there may be a lot of competition, but it is amongst small ‘monopolies’. For ex, there are lots of cafes in Paris but some are nearer your hotel than others and none of them are exactly the same. This is thought to be harmful because in equilibrium prices are shown to diverge from marginal costs. So the result isn’t quite that of the ‘perfect’ competition model where price equals m costs. • But so what? If people like ‘variety’, if they value distinctiveness, and are prepared to pay slightly higher than ‘perfectly’ competitive prices, who are we to call it harmful? Would we be better off if every café was exactly the same? industrypartsa/b

How extreme an assumption? • In the SR perhaps not so extreme. • But in the longer run it is extreme for the simple reason that the existence of mon profits will encourage the development of closer substitutes. So the question for the monopolist is how long will this take? (And what can it do to slow it down?) If it seems technologically unlikely the mon can rest easy. But technology has a way of surprising us. Need I mention the internet? • This is important because harmfulness is related to longevity. Short lived mons are not a big problem. industrypartsa/b

‘New economy’ critique of MP • A group of authors/consultants argue that the nature of new economy (1990’s style) makes market power less sustainable than ever. • Consultants such as McKinsey (creative destruction), PWC (continuous transformation), and authors such as Prahalad-Hamel (competing for the future), D’Aveni (hyper-competition), Wood (complexity) and Brown-Eisenhardt (competing on the edge) and Mendelson (organisation IQ) all argue basically that profits are increasingly transitory, temporary, short lived, and impossible to sustain. • A composite view of these authors is next. industrypartsa/b

Comp in the new economy • All profits are transitory. They always attracts competition and get squeezed. Success (?) generally comes from attack not defence. No business can stand still. Not even a Microsoft. Success needs to be constantly renewed by continued investment efforts. This depends on: • Creativity, innovation, newness, surprise, initiative, flexibility, speed of reaction, decisiveness, opportunism, anticipation, reinvention, organisational intelligence, identifying and exploiting the right options, energising the business. • That is on developing and using competitive capabilities to produce a competitive advantage, not on static mon power. industrypartsa/b

Note on semantics • Industry is an unsatisfactory term. • It is ok for some purposes to talk of the hotel industry, the publishing industry, the auto industry. But it is imprecise. • Competition is about specific markets not industries. Think of industries such as hotel, publishing, auto, education, finance, pharmaceuticals? In hotels we have luxury hotels, mid range hotels, cheap and cheerful, backpackers. (US/EC/SEA etc) In drugs, there is no single market, but dozens of distinctive markets relating to particular problems. • Point? Competition is about reasonably well defined distinctive markets for particular customer segments in particular places. • In autos it is true in general that Ford ‘competes’ with VW. But even here the important action is in well defined market segments (small cars say) in particular areas (UK). industrypartsa/b

Defining the market • Anti-trust authorities need to be able to define relevant markets and this can be difficult. Essentially what they wish to identify is a situation in which a hypothetical monopolist could raise prices significantly and sustainably (say over 5% for a year). To do this they need to consider the demand side, supply side and geography. SEE also L&W on this, chap 6.2 industrypartsa/b

On demand side they would consider the extent to which consumers perceive products to be substitutes. If oranges are considered a very good sub for apples but not for bananas then o/a are part of the same market but bananas are not • On supply side they would consider how easy it might be for producers to switch production between goods. For example if a cola bottler can switch to bottling water with ease but not milk then the first two are closer subs. • On geography they would consider whether a hypothetical monopolist could sustain a price rise in region x. If so, that is the relevant market, if not, define a bigger region until the answer is yes. industrypartsa/b

NB • A monopolist will set price where demand is elastic, where subs begin to make their presence felt. So the existence of subs for a mon market it is argued doesn’t per se indicate there is enough potential competition at present. The question should be, ‘would there be any serious subs at the comp price in the relevant market’? If not, then the market is effectively monopolised. industrypartsa/b

Economics of industry