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Lecture 1

Introduction
L12418 Industrial Economics

Dr Matthias Dahm

January 2014
University of Nottingham
School of Economics

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L12418 Industrial Economics


Lecturer: Dr Matthias Dahm
Office hour in SCGB B47: email for appointment
(but most weeks Wednesdays 11-12 a.m.)
Teaching methods
18 Lectures
Tue. 11 a.m. (LASS-B63) & Wed. 10 a.m. (LIFESCI B3)
slides: will be available on Moodle before lecture

3 Tutorials: weeks 23, 25 and 27 - sign up via Moodle


Alex Possajennikov teaches some tutorials
aim is to deepen understanding of material via exercises
aim is to make students think some exercises are challenging
students are expected to prepare answers before the tutorials
tutorial sheets/solutions: will be available on Moodle
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L12418 Industrial Economics


Method of assessment: 2 hour written exam (100%)
answer two questions (one compulsory, one out of three)
previous examination papers and feedback for all modules can
be viewed online in Moodle
feedback exercises toward the end of the module

Marking criteria
questions have analytical & theoretical part
answers should be rigorous and show modeling skills
requires to work through the exercises

answers should show perspective on module content


requires to do the reading assignments

Pre-requisite: L12302 Microeconomic Theory


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L12418 Industrial Economics


Module Texts

PRN Pepall, L., Richards, D. & Norman, G. (2010).


Contemporary Industrial Organization: a quantitative
approach. Wiley.
LWG Lipczynski, J., Wilson, J.O.S. & Goddard, J. (2013).
Industrial Organization: competition, strategy, policy.
4th edition. Pearson.
M Martin, S. (2010). Industrial Organization in
Context. Oxford University Press.
CW Church, J.R. & Ware, R. (2000) Industrial Organization: A Strategic
Approach. McGraw-Hill.
Available at: http://works.bepress.com/jeffrey_church/23
CP Carlton, D.W. & Perloff, J.M. (2005). Modern Industrial
Organization. 4th edition. Pearson Addison-Wesley.
C Cabral, L.M.B. (2000). Introduction to Industrial Organization. MIT
Press.
BP Belleflamme, P. & Peitz, M. (2009). Industrial Organization.
Cambridge University Press.
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L12418 Industrial Economics


Aim of Module

Comprehensive and coherent overview of Industrial Economics


Empirical and theoretical approaches (but emphasis on latter)
Topics may include:
Market Structures
From Perfect competition to Monopoly via Oligopoly, including
Product Differentiation
Strategies and Conduct of Firms
Collusion; Price discrimination; Entry deterrence; Vertical
relationships; Advertising; Research & Development
Regulation of Industries
Regulation of monopolies; Antitrust laws; Public policy

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What is Industrial Economics?

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What is Industrial Economics?


BBC on 16 January 2014 Labour to force bank break-ups

Labour officials say:


. . . Britain has one of the most concentrated banking systems
in the world, with just four banks controlling 85% of small
business lending. . . excessive market power of banks
. . . break up of the UKs largest retail banks. . .
. . . create two new large banks to challenge the existing big
banks. . .
. . . expect the new challenger banks to each have at least 6%
of the personal current account market. . .
. . . A new maximum threshold for market shares which would
trigger future CMA investigations if banks grow above that
size. . .
. . . and an automatic ban on any takeover that created a
bank bigger than the threshold.. . .
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What is Industrial Economics?


BBC on 16 January 2014 Labour to force bank break-ups

Bankers say:
. . . this would lead to what they call a perverse outcome. . . as
they approached the maximum size they would dump
customers they deemed low quality or loss-making. . .
The governor of the Bank of England, Mark Carney says:
. . . just breaking up an institution doesnt necessarily create a
more intensive competitive structure... Its not just about one
aspect. You need to look at the entire business model and risk
profile.

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What is Industrial Economics?


BBC on 16 January 2014 Labour to force bank break-ups

Key questions:
What is the relationship between market structure and
economic performance?
If we observe that there are only a few large banks, can we
conclude that they have excessive market power?
LWG p. 18: Case study on market structure and performance in
European banking.
PRN p.14:
The reason we study industrial organization is to
understand market competition in all its dimensions and
to develop appropriate public policy when the market
imperfections in that competitions yield unsatisfactory
outcomes.
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What is Industrial Economics?


Industrial Economics is a synonym for Industrial Organization
The study of real world markets:
market for operating systems
computer ship market
soft drink market
...

These are not markets with numerous small firms


The perfectly competitive model does not apply
Industrial Economics is the study of imperfect competition
Industrial Economics provides the basis for regulation and
competition policy
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How do we study Industrial Economics?


Who won last years Nobel Prize in Economics?

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How do we study Industrial Economics?


Jean Tiroles approach (Royal Swedish Academy of Sciences)

He has created a unified framework for IO theory and


regulation, founded on a rigorous analysis of strategic
behavior and information economics
By deploying a consistent conceptual framework over a wide
range of issues, he became a leader in the creation of the first
encompassing and coherent theory of IO
his rigorous thinking has overturned previous conventional
wisdom
Tirole has shown how the justifications for public
intervention frequently boil down to problems of information
asymmetries and credible commitments. These general lessons
- together with a catalogue of specific applications - form a
robust foundation for policy analysis
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How do we study Industrial Economics?


Formal mathematical modeling allows
careful thinking about complex world
to see how each assumption influences the outcome
to derive testable predictions

Game theory allows


analysing strategic interaction between firms
when decisions are interdependent

Tool kit contains different models, as markets are different:


a few large firms or one large and several small firms
differentiated products or identical ones
price competition or non price competition (like advertising)
...
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Traditional Industrial Organization


The field of industrial economics emerged:
Context of antitrust policy in U.S.
Tried to give guidelines to competition policy
Aimed to make coherent argument to guide legal decisions
E.g. did U.S. Steel abuse monopoly power (1920)?
Can one infer illegal behaviour from firm size or structure?
Traditional Industrial Organization was based on the
structure-conduct-performance paradigm

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The structure-conduct-performance paradigm


Seminal early contributions (after 1930):
Identify links between market structure and market outcomes
Obtain data on prices, profits and market structure
Identify statistical relationships between structure and
performance
Basic principle:
There is a spectrum of market structures
At opposite ends are monopoly and perfect competition
All markets lie along this spectrum

Determine from observable evidence whether industry in


question is closer to monopoly or perfect competition
Provide road map for policy, like by how much raises a bit
more concentration prices above costs?
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The structure-conduct-performance paradigm

LWG, Figure 1.1

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The structure-conduct-performance paradigm


Slide 1.2

Figure 1.1

The structureconductperformance paradigm

LWG, Figure 1.1

Lipczynski, Wilson and Goddard, Industrial Organization PowerPoints on the Web, 4th edition Pearson Education Limited 2013

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Main criticisms of the SCP paradigm


1) Empirical findings can be interpreted in different ways.
SCP researchers produced vast amount of empirical findings
like firms with large market shares tend to earn greater profit.
SCP researchers: collusion hypothesis
the higher market share, the greater monopoly power, the
higher profit
Chicago school: efficiency hypothesis
Some firms have superior technology and talent (are more
efficient, as costs lower) and have thus both larger size and
higher profits
Implies: punishing largest firms means punishing success
Cournot model in which costs differ across firms supports
latter view
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Main criticisms of the SCP paradigm

2) Strategic interaction has important role.


The nature of rivalry between firms determines market
outcomes
Even markets with only two firms can produce very
competitive outcomes
Bertrand model supports latter view

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Main criticisms of the SCP paradigm


3) Structure is itself endogenous.
Conduct affects structure: e.g. firms deciding to merge
generate higher concentration
Performance affects structure: e.g. firms making losses have
to exit the market
The direction of causality is not clear
Market structure is not exogenous and treating it as such
leads to misspecification of regressions and biased or
inconsistent results

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Main criticisms of the SCP paradigm

4) There are measurement issues.


Performance: accounting profit vs economic profit
Definition of the relevant market
Variables might belong to several categories (e.g. product
differentiation is structure or strategy and thus conduct?)
Quantification of variables (e.g. how do we quantify
collusion?)
...

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Beyond the SCP paradigm


Although SCP paradigm is useful in a number of ways (e.g. to
organise information or even to organise the analysis . . . ),
the response to the criticisms was recognition that structure is not
the most important determinant of the level of competition.
Instead:
examine the logic and reasonableness of a firms conduct
explore strategic behaviour on a consistent basis
at the same time an analytic framework for examining
strategic interaction emerged: Game theory
development of theories that focus primarily on strategy and
conduct
field has been transformed, some call it: New Industrial
Organization
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Main source for lecture today

Pepall, L., Richards, D. & Norman, G. (2010). Contemporary


Industrial Organization. Wiley.
Chapter: 1
Lipczynski, J., Wilson, J.O.S. & Goddard, J. (2013). Industrial
Organization. 3rd edition. FT Prentice Hall.
Chapter: 1

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