Chapter 3: Industrial Organization

3.1 Market Power

 market is efficient only if P = MC, the more price deviates, the lower the market welfare is
 market power
o ability of a firm to sell its products at a price above marginal costs
o how much the market pricve deviates from MC and how efficient it is
o measure of market power: Lerner index (L)

 , competitive L = 0
 firms can establish non-negligable market power by forming cartels
(even L = 30%)
o to measure market power in a market we use weighted average of the Lerner indices of
the firms, the weights are market shares
 a market share of a firm is

 , firm revenue divided by total market revenue

 firm I at MC and p
o Lerner index for the market


o obtained by copyrights etc patents
o also without law protection
 advertising, collusion, M&A, predatory behavior
 welfare consequences
o at first, price doesn’t matter much, the loss in CS is compensated by PS
 however some consumers don’t buy -> quantity sold goes down and prevents
some value-enhancing transactions
 power power induces allocative efficiency

 consider demand and

 

 , reverse it to this

o DWL equals
 quadratic function of the diffderence between price
and MC
 loss may be even greater due to productive
inefficiency, dynamic inefficiency or influence costs
o firms with market power have an easier life due to lack of
competition
 they may experience little pressure to reduce costs
(productive inefficiency) or to innovate (dynamic
inefficiency)
o influence costs add to efficiency loss: firms with market power
could lobby the gov to protect their market power by eg
restricting imports – resources are spent in lobbying
o market power can be beneficial; the prospect of power gets firms to innovate
 that’s why govs award patents etc
 welfare may be even lower if they didn’t give it out

3.2 Market Concentration

 market is concentrated if only a handful of firms have a serious combined market share
o only in concentrated markets firms have significant market power
 plays an important role in policy
 Herfindahl-Hirschman index (h)
o measure of market concentration
o sum of the squares of the market shares of firms


 H = 1 is a monopoly, H = 0 has. many small firms
 in the case of n equally sized firms
 o , indicates that H is a natural measure, the more
equally sized firms are active, the lower the index, also
described by number of firms


o competition authorities use it to estimate effects of mergers
o market power and concentration are linked by

 , where represents the price elasticity of demand

 we can find firms with considerable market power in concentrated markets
(high H) where demand is price inelastic (low e)
 practical reason for calculating the H index is because market shares are way
easier to obtain than marginal costs

3.3 Monopoly: The Inverse Elasticity Rule

 electricity, water, etc. are monopolies + those protected by patents
 extreme end of possible market concentrations, H = 1 as market share 100%
 what price should the shop charge the cyclist


 derive MR from the table, selling a 4th bottle is not profitable even
though there is still demand
o shortcut to monopoly firm’s profit-maximizing price is the ‘inverse elasticity rule’


 exactly follows equating MR = MC
 

3.4 Government Intervention

 role for gov. intervention in market power
 competition policy
o to promote competition – competition law
o three pillars
 anti-cartel law – forbids cartel agreements


o 101 article
 exdemptions in EU – speicifc markets (car industry – to promote
progress and reasearch in joint ventures)
 abuse of dominant position
 dominant firms are not allowed to abuse their power
 102 article
 o

 merger control
 blocking mergers, acquisitions and far-reaching joint ventures


 EC evaulates based on market shares & concentration for the mergers

o also, a concentrated market need not have market power – bcs
disciplined by threat of entry or facing buyers with a strong
bargaining position’
 sometimes also state aid control
 gov. directly and indirectly supporting xcompanies on a selective basis
that might distort competition
 article 107
o

 economic regulation
o only applies to specific markets
o regulated are usually natural monopolies – where prod. by a single firm minimizes costs
 electricity, railway, big infrastructure industries
o supervised by a regulator that can intervene to mitigate welfare losses by imposing e.g.
max prices – often price inelastic demand – reasonable to intervene; welfare loss could
be substantial otherwise
o rate of return
  regulator sets price such that the firm is exactly compensated for the costs
including a fair rate of return – allocative inefficiency is reduced as much as it
can
 disadvantage – little motivation for the firms to reduce costs if they’re still going
to be stripped of the profits
o under-price-cap
 the regulator sets a max price for a long period of time, taking inflation and tech
progress into account
 reduces allocative and productive inefficiency
 disadvantage – may not be straightforward to find price, many factors; should
be p = MC of the firm but they don’t know the MC exactly
 also, strong commitment from regulator; ratchet effect is possible –
when firm decreases costs, regulator is tempted to reduce the max.
price