IO Ch. 15

In the last chapter we examined a numerical, theoretically derived formula to address the optimal number of firms in a particular industry. According to this simple economic theory, the number of firms should be a function of market size and the cost function in a particular industry.

Of course the reality is far more messy. Established firms use a number of strategies to keep new firms from entering, so that they can maintain market power. These strategies include:

1. increasing production

Ex:DuPont (titanium dioxide)

2. product proliferation

Ex: cereal market

3. Contracts

Ex: Monsanto

4. Predatory pricing

Ex: Airlines

5. Nonprice Predatory behavior

Ex: Microsoft - bundling/tying

6. Merging

Ex:Daimler-Chrysler, Microsoft

Which of these strategies a firm will use depends on the structure of their industry.

For instance, the ability to increase production is linked to capacity, which in some industries is harder to increase than in others.

Also, the need and/or effectiveness of such a strategy will vary depending on the barriers to entry.

With high barriers to entry, firm's best strategy is to act like a monopoly.

With low barriers to entry, firm's best strategy is to assume there will be entry.

It's in the middle where increasing production may reduce the threat of entry.

In the case of contracts, again it depends on the type of market. Monsanto was able to capture most of the market because there are only two major buyers of Nutrasweet, Coke and Pepsi. Could an airline company use this strategy?

Why should economists care about these actions?

As before, we can look at the impact on other firms and consumers, although I would put more emphasis on the impact of other firms, particularly new entrepreneurs, than the book does.

In the case where production is increased in the short run, consumers benefit from higher Q and lower P, but this could be short-lived. It depends on how constant the threat of entry is.

In the case of cereals, consumers benefit from more choice, but they pay in terms of higher prices. It is probably the case that too many types of cereal are being produced.

But of all of these strategies, the ones of particular concern to policy makers are 4, 5 and 6.

Predatory pricing looks beneficial to consumers in the short run, but in the long run, once the threat of competition has been eliminated, the firm is likely to go back to it's monopolistic behavior. In addition to consumers potentially losing out (and allocative inefficiency resulting), new firms/entrepreneurs are kept out of the market.

The US government uses two criteria for determining whether a firm has been practicing predatory pricing: p<MC (The Areeda-Turner Test) and an examination of the history of prices, to see if there is a large drop and then a large rise (post-exit price increase).

Proving predatory pricing is not easy though, because 1. firms may legitimately price below MC for a short period of time, 2. it is often difficult to tell the difference between competitive pricing and predatory pricing, particularly if the price is hovering just around MC.

Also, the benefit of predatory pricing could be long or short term, depending on whether the new entrant stays in the running for a while or even forever.

One school of economics (the Chicago school) theorizes that predatory pricing is irrational and therefore does not exist. They base this on the assumption that because there is a profit to be made, new entrants should just ride out the low price period, until the existing firm realizes the losses are too great, and then they settle into a duopolistic existence. Unfortunately, there this theory requires the new entrants to have the same access to cash (so that they can operate at a loss), which is a problematic assumption. Of course this same school also theorizes that discrimination is irrational and therefore doesn't exist. In both cases there is empirical evidence to the contrary.

In terms of nonprice predatory behavior, we looked at the example of Microsoft.

Clearly a final way to gain market power is through mergers. Here again the costs and benefits are complicated.

On the one hand, merging may lead to cost savings which may be passed on to consumers (or maybe not...) On the other hand, it is likely that Q < Q1 + Q2. (Think about the reverse, the move from monopoly to duopoly.) What can we say about dynamic efficiency? Merging may also lead to efficiency gains in terms of R and D. But at the same time we discussed the example of Microsoft, where merging means squashing new products which may be better than those currently on the market. So do mergers help or hurt consumers? It's a mixed bag. Do mergers help or hurt rival firms? It depends. It increases the chance of collusion.

Mergers occur to shore up market power, but they may also be pushed by exogenous events.

For example one explanation of the series of mergers in the grocery store industry was the entrance of Walmart into the market. But what are the consequences for the industry, as well as up and downstream industries. This is something the book doesn't spend a lot of time discussing, but we will talk about it next class.

One thing all these strategies have in common is that they prevent or squash new entrants. Again, the book does not focus much on this angle. It seems to me that there is some value to economic diversity and opportunities for small entrepreneurs. Will we eventually become a nation of megastores, with a few 'entrepreneurs' and everyone else being employees? (Fortunately there seem to be some areas where returns to scale do not work towards mergers.)

The other conclusion we can draw from this chapter is that although we have a nice theoretical way of deriving n - the optimal number of firms, the reality is likely to be far messier.