INTRODUCTION TO Industrial Organization Luís M. Cabral Introduction to Industrial Organization The MIT Press Cambridge, Massachusetts . London, England Second printing, 2002 © 2000 Massachusetts Institute of Technology All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from the publisher. This book was set in Melior and MetaPlus by Windfall Software using ZzTEX and was printed and bound in the United States of America. Library of Congress Cataloging-in-Publication Data Cabral, Luı́s M. Introduction to industrial organization / Luı́s M. Includes bibliographical references and index.6—dc21 00–038666 CIP Contents Preface xi P A R T O N E Introduction 1 C H A P T E R 1 What Is Industrial Organization? 3 1.3 Coming Next 11 Summary 12 Key Concepts 13 Review and Practice Exercise 13 C H A P T E R 2 Basic Microeconomics 15 2.4 Efficiency 26 Summary 29 Key Concepts 29 Review and Practice Exercises 30 Extension Exercise 33 C H A P T E R 3 The Firm 35 3.1 Do Firms Maximize Profits? 35 3.2 What Determines the Firm’s Boundaries? 40 3.3 Why Are Firms Different? 42 Summary 45 Key Concepts 45 Review and Practice Exercises 45 Extension Exercises 46 vi Contents C H A P T E R 4 Games and Strategy 49 4.1 Dominant Strategies, Dominated Strategies, and Nash Equilibrium 51 4.2 Sequential Games: Commitment and Backward Induction 55 4.3 Repeated Games 59 Summary 62 Key Concepts 63 Review and Practice Exercises 63 Extension Exercise 66 P A R T T W O From Monopoly to Perfect Competition 67 C H A P T E R 5 Monopoly and Regulation 69 5.3 Essential Facilities and Access Pricing 78 Summary 82 Key Concepts 82 Review and Practice Exercises 83 C H A P T E R 6 Perfect (and Almost Perfect) Competition 85 6.2 From Theory to Stylized Facts 87 6.5 Coming Next 94 Summary 96 Key Concepts 96 Review and Practice Exercises 96 PART THREE Oligopoly 99 C H A P T E R 7 Oligopoly Competition 101 7.1 The Bertrand Model 102 Contents vii 7.2 Pricing with Capacity Constraints 104 7.3 The Cournot Model 107 7.4 Bertrand versus Cournot 113 7.5 The Models at Work: Comparative Statics 114 Summary 124 Key Concepts 124 Review and Practice Exercises 125 Extension Exercise 126 C H A P T E R 8 Collusion 127 8.1 Repeated Interaction and the Stability of Collusive Agreements 128 8.3 Factors That Facilitate Collusion 137 8.4 Public Policy 144 Summary 145 Key Concepts 145 Review and Practice Exercises 146 Extension Exercises 150 C H A P T E R 9 Market Structure and Market Power 151 9.1 Concentration and Market Power: Theory 151 9.2 Concentration and Market Power: Empirical Estimation 156 9.3 Conduct and Market Power: Empirical Estimation 159 Summary 162 Key Concepts 163 Review and Practice Exercises 163 Extension Exercises 163 P A R T F O U R Price and Nonprice Strategies 165 C H A P T E R 10 Price Discrimination 167 10.1 Types of Price Discrimination 169 viii Contents 10.2 Third-Degree Price Discrimination 170 10.4 Versioning, Bundling, and Other Forms of Consumer Sorting 175 10.5 Is Price Discrimination Legal? Should It Be? 180 Summary 183 Key Concepts 184 Review and Practice Exercises 184 Extension Exercises 187 C H A P T E R 11 Vertical Relations 189 11.1 Double Marginalization and Two-Part Tariffs 190 11.6 Are Vertical Restraints Legal? Should They Be? 199 Summary 200 Key Concepts 200 Review and Practice Exercises 201 Extension Exercises 203 C H A P T E R 12 Product Differentiation 205 12.1 Horizontal Differentiation, Vertical Differentiation, and the Characteristics Approach 206 12.2 Product Differentiation and Market Power 209 12.4 Imperfect Information and Switching Costs 217 Summary 219 Key Concepts 220 Review and Practice Exercises 220 Extension Exercises 221 Contents ix C H A P T E R 13 Advertising 223 13.1 Information, Persuasion, and Signaling 223 13.3 Price Competition and Advertising 231 Summary 235 Key Concepts 235 Review and Practice Exercises 235 Extension Exercises 237 P A R T F I V E Entry and Exit 239 C H A P T E R 14 Entry Costs, Market Structure, and Welfare 241 14.1 Entry Costs and Market Structure 243 14.2 Endogenous versus Exogenous Entry Costs 247 14.3 Free Entry and Social Welfare 252 Summary 256 Key Concepts 256 Review and Practice Exercises 256 Extension Exercises 257 C H A P T E R 15 Strategic Behavior, Entry and Exit 259 15.3 Mergers and Acquisitions 277 Summary 285 Key Concepts 286 Review and Practice Exercises 286 Extension Exercises 288 P A R T S I X Technology 289 C H A P T E R 16 Research and Development 291 16.1 Market Structure and Incentives for R&D 292 16.2 The Dynamics of R&D Competition 295 x Contents 16.3 Public Policy 303 Summary 308 Key Concepts 308 Review and Practice Exercises 309 C H A P T E R 17 Networks and Standards 311 17.1 Consumer Expectations and Critical Mass 312 17.3 Excess Inertia and Excess Momentum 319 17.5 Public Policy 326 Summary 328 Key Concepts 329 Review and Practice Exercises 329 Extension Exercises 331 Notes 335 Index 347 Preface Why yet another text on industrial organization (IO)? IO texts are not in short supply, and so the question is only fair and natural. Accordingly, this preface provides a convincing answer to this opening question. Industrial organization has changed a great deal over the past two decades. Most importantly, it has evolved from a niche area in economics to an independent discipline that is studied by most economists and by students and scholars in areas such as finance, marketing, and strategy. This shift has resulted from two factors: (1) IO is the first economics discipline to incorporate the developments in game theory that took place during the late 1960s and 1970s, and (2) the analysis of imperfectly competitive markets (a possible definition of IO) is an inherently interesting and important task. The evolution of the status of IO has not been reflected in the supply of new IO texts. Although the latter have increased in number, one cannot avoid the feeling that most texts have been written primarily for an audience of advanced undergraduate economics students; and in some cases for students who intend to pursue an academic career in economics. Why do I say this? First, because the level at which they are written is somewhat advanced for a student who does not have economics as a primary field of study. Second, many of these texts are methodology driven rather than issue driven: They introduce readers to a collection of models and econometric regressions as if to initiate them in the activity of research in IO—which is a natural bias, given that most authors are well-known IO researchers. This text fills the perceived gap: Here, then, is a text that will appeal to a wide audience of readers, including economics students as well as students from other areas a G. Chesterton once wrote a long who are interested in economics as part of their education. Accordingly, the two main letter to the editor of a newspaper. objectives of this book are the following: Asked why he wrote such a long letter, he allegedly answered, “Because I didn’t have the time 1. The book is an introduction. This is naturally reflected by its length, between one to write a short one.” I consider its third and one half of the size of most other texts. However, brevity is achieved not relatively short length as one of the so much through superficiality in the treatment of each issue, but rather through accomplishments of this text. greater selectivity in the list of topics addressed.a b In particular, I should emphasize that the list of references in the 2. The book is issue driven rather than methodology driven or literature driven. book does not reflect a balanced Although I make extensive use of models (because I think they are a useful way survey of the IO literature. To stress this point, I have chosen not of understanding reality), I introduce a new model only when this is justified in to make direct reference to sources terms of the marginal benefit in understanding an issue.b in the text, leaving bibliographic references to notes at the end of the text. (These are the notes Studying this book will not make the reader an expert in industrial organization; marked with numbers, as opposed nor will it provide a complete or even representative view of two decades of research to footnotes such as this one, which in the field. However, it will give an idea of the main issues involved in the analysis are marked with letters.) xii Preface of market competition, and in applying these ideas to the understanding of relevant problems reported in the Wall Street Journal, Financial Times, Economist, and related publications:c How should Nintendo react to Sony’s cutting the price of its PlayStation? Was the Department of Justice right in suing Microsoft for bundling Windows with Internet Explorer? How will the proposed merger between British Airways and American Airlines impact on transatlantic airfares? Should the European Union allow the merger? And so forth. This text is as up-to-date as possible. Although most of the developments in IO occurred during the 1980s, it is surprising how many are still not included in textbooks. Although their original treatment is rather technical, the basic ideas are sufficiently important to warrant a simplified textbook treatment. Examples include the analysis of price competition with capacity constraints, dynamic models of collusive behavior, competitive selection, endogenous entry costs, and vertical restraints. The text strikes a balance in terms of the relative weight of ideas and examples and of the relative weight of U. Some of the examples are presented in separate boxes, of which there are more than thirty in the book; most are introduced in the main text. Readers should be familiar with basic economics, at the level of Economics 1. Those less familiar with the background concepts necessary for IO can start with chapter 2, a primer in microeconomics that covers the necessary concepts for the purpose of this book. The basic text consists mostly of graphical analysis. This is complemented by a series of supplemental materials (posted on the web) that make more extensive use of algebra and calculus. In this way, the book is sufficiently flexible to accommodate readers of different technical backgrounds. Although the basic text is self-contained without the mathematical sections, readers familiar with algebra and differential calculus will find the supplemental sections helpful. The exercises at the end of each chapter are divided into “Revision and Practice” exercises and “Extension” exercises. The titles are self-explanatory. Extension exercises typically consider generalizations of results presented in the main text. Exercises are classified from (no asterisk) to ∗∗∗, according to level of difficulty. The book’s website may be accessed at the following address: http://luiscabral.org c The number of citations to At this site, readers will find advanced mathematical sections, additional examples and newspaper articles in this book is approximately equal to the number case studies, solutions to exercises, and other materials of interest. The site also includes of citations to scholarly articles. sections especially designed to help instructors. Preface xiii ACKNOWLEDGMENTS Several people helped me with comments on previous drafts of several chapters: Dan Ackerberg (Boston), Mark Armstrong (Nuffield College), Helmut Bester (Berlin), Bruno Cassiman (Pompeu Fabra), Pascal Courty (LBS), Joe Farrell (Berkeley), David Genesove (Jerusalem), Ben Hermalin (Berkeley), Francine LaFontaine (Michigan), Ramiro Tovar Landa (ITAM, Mexico), Frank Mathewson (Toronto), Michael Peitz (Frankfurt), Rob Porter (Northwestern), Michael Riordan (Columbia), John Small (Auckland), John Sutton (LSE), Frank Verboven (Antwerp), Reinhilde Veugelers (Leuven), Len Waverman (LBS), and Peter Zemsky (Insead). To this list, I should add the various anonymous reviewers who also took their time to read previous drafts.
