Economics of industry
The economic consequences of
market power, the foundations of
• 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
• A deliberately critical evaluation. Economics is
about learning how to think not what to think.
• 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.
Chap 1.2 (views of competition),
• 2.5/ 2.6 (basics of case for competition),
• 10.3 (price discrimination and
• 14.2 (Arrow model and innovation)
• and 17.2 and 18.2 (more on basic case
against m power)
• A. The problem outlined: the monopoly model,
monopoly power, and economic efficiency
• B. The debate started: examining the foundations of the
• 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
• E. Other aspects: consequences re vertical integration/
M&As discussed later
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?
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
• 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
• Contrasting two schools of thought: the
mainstream Harvard SCP school and its Chicago
• Leads us to a consideration of 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
• This tells us what C policy is about and its
• 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.
• 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.
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.
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’.
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
• 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.
• 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.
• 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,
Monopoly and alloc. efficiency
• Diagram one (at lecture)
• 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
• Diagram two
• 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
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.
• 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!
• 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)
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
• 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 ….
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.
• Diagram 3
• 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.
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?
• 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.
• 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
• 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
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.
• 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?
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.
• 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
• 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.
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.
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
• Assumptions (1,2,…10) examined in turn.
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!
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!
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.
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
• 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?
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.
‘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.
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
• That is on developing and using competitive capabilities to
produce a competitive advantage, not on static mon power.
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
• 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).
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
• 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.
• 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.
• Needless to say in practice defining the relevant
market is one of the most contentious areas of
comp policy. The authorities will tend to seek a
narrower definition than producers.
• Take newspapers. What market is the Sun part of?
Tabloids only, or all national newspapers and
news magazines? What about free newspapers
and local newspapers? What about TV news
programmes? And nowadays the internet? Plenty
of scope for arguing.
• Try the market for alcoholic beverages.
3. Entry is blocked
• Potential rivals find it unprofitable to enter the
market to take on the profitable incumbent so no
need for incumbent to make allowances for this
possibility despite there being incentives to enter,
in the form of the profit opportunities.
• Again possibly an extreme assumption in the long
run although it is true that incumbents have
incentives to actively invest in the creation of
entry barriers to seek actively to discourage rivals
(more details on this later under oligopoly).
Extreme? : Consider
• The many markets that had very powerful incumbents and
apparently very high barriers to entry that eventually
succumbed to successful entrants.
• The US auto industry pre Japanese invasion, IBM before
the PC revolution, the UK steel industry, the telecoms
market, Xerox, Dunlop, Woolworths, etc
• All profits are transitory. See slides above on this
• Same idea re barriers this time. Barriers to entry not what
they were. Many towns had only one or two booksellers,
banks, record stores. And along comes Amazon and co
and jumps the barriers.
The cherry picker strategy
• Entrants need not, and generally do not, take on the
dominant incumbent directly, ie do not seek to replicate the
dominant firms business model.
• There is the possibility of the ‘cherry picking’ strategy,
where entrants seek to identify particular segments of the
market where they might prosper. Where perhaps
entrepreneurial alertness/ flexibility overcomes the
advantages of size.
• For example when postal services have been liberalised
new entrants are often accused of cherry picking, ie
focusing on the most attractive bits of the market like big
cities, or business mail, or parcel services.
• And think how the bottled water market has developed.
Consider re barriers
• The question of harmfulness. If mon is harmful
by implication so are the barriers protecting it.
• But can all ‘so-called’ barriers really be harmful?
• For example a standard ‘barrier’ identified in all
the textbooks is the ‘absolute cost’ barrier. These
are said to arise from first-mover advantages
based on scale or the ‘aggressive’ chase down the
learning/ experience curve or reputation etc.
• But why is this harmful? What is meant? Can
there be competition without aggression, without
someone trying to be a winner?
• This situation described could be seen as the
natural result of one business taking the risks
(making commitments) involved in developing a
new product and moving first to develop the
market. The reward is possibly an early cost
advantage but remember in fact not all first
movers become long term winners (Apple!). So
could the ‘advantage’ be seen as a reward for the
socially useful risk of pioneering.
• Also network effects (see next slide), create
barriers which protect some companies but this
seems to result from consumer choice. This might
be tough luck on the competition but is it harmful?
• A factor encouraging dominance but deriving from the
demand side. Idea is that for some products/ services, the
value of ownership/use increases the more owners/users
there are. Because of the benefits of the growing network
(installed base) of users.
• For most products this doesn’t apply. VW cars don’t
become more valuable to you as more people acquire
them. Au contraire.
• But for some things it does. Software for example.
Microsoft arguably owes is success to this effect.
Consumers value compatibility/ transferability and so we
have all tended to adopt the same OS and related software.
Could have been Apple, or IBM. A dominant supplier was
likely to emerge here.
• However deliberately created ‘strategic barriers’ may be
• Product differentiation, advertising and brand names,
product proliferation, predatory pricing are seen by some
as deliberate ‘strategic’ actions aimed at protecting a
business from entrants. But is this always the case?
• Take advertising. Admittedly some may indeed be
‘strategic’. But adv can also be socially valuable because
consumers value information about product specs,
qualities, options. How else can we learn about what’s
available? Or product proliferation in cereals/ toiletries etc
which could be seen as improving consumer choice.
Two ways of seeing
• It seems there are (at least) two ways of seeing
firm behaviour. One looks at it as largely about
on going competitive efforts to get and stay ahead,
a treadmill, the other sees most firm actions as
attempts to ‘destroy’ competition with negative
social effects. Thus even if a monopoly has ‘low’
prices because it is worried about the threat of
entry etc it can be attacked for ‘predatory’
behaviour (as Microsoft has been).
• Maybe the competitive process is inherently
double edged. Some see a half filled glass, others
a half empty glass.
4. Profit maximisation
• Mon model assumes p max. Extreme? Possibly,
think back to the possibility that for various
reasons some firms pursue objectives other than
profit such as size/ and growth (Marris).
• If so, this would lead away from the ‘harmful’
outcome nearer to the competitive outcomes for
• Eg the Baumol (profit constrained sales
maximisation) model (see George) must lead to
lower prices and higher output.
5. No price discrimination
• Standard model assumes there is no price disc by
• First, consider the principle of p discrimination.
Charging individual consumers (or groups of
consumers) different prices according to their
maximum ‘willingness’ to pay for the product.
• In the standard monopoly model (see fig) the
initial monopoly profit rectangle is ‘captured’ or
appropriated consumer surplus. But this leaves a
lot of consumer surplus unexploited. Price disc is
an attempt to exploit it more fully.
Diagram 4 : Price discrimination
Explanation in lecture
industrypartsa/b Q 62
Degrees of price disc
• 1st degree: where you seek to extract/ appropriate
the whole of the available consumer surplus
• 2nd degree: where consumers pay a different price
according to the quantity they choose to buy
(quantity discounts, multi packs)
• 3rd degree: customers are segmented by type (age/
sex/location/…) and charged according to the
segments willingness to pay.
• See a good text such as George/ Church et al for
details of these and examples
The paradox of price disc
• If a monopolist can achieve p disc a potentially
paradoxical result arises. The social harm of
monopoly falls. Paradox because a price disc mon
is more powerful than before but less ‘harmful’.
• Why? Because it gets nearer to the desired
allocative efficiency (ie competitive) output!
• Of course the distribution of income outcome
might not be acceptable but that is not an
efficiency issue, it is an ethical/ political one, an
issue of judgement which economists are no better
at deciding than plumbers or dentists.
However re price disc
• We have to note that whilst all mons would seek
to use p disc it is not always possible to do it in
practice. And it is not a costless exercise. There
fore not all will actually be observed doing it.
• Difficult?: first because of information problems
(about consumer willingness to pay) and second
because of arbitrage problems (clever
• So should competition policy encourage it or
6. Cost differentials
• The standard mon model assumes that the mon
and the comp industry have the same level of
costs. No economies of scale exist. The LRAC
curve is flat.
• But this is strange. Because a major reason for
mon will be economies of scale (and scope)
benefiting large-scale operations (car assembly or
supermarkets say), so the mon generally will have
lower costs. So is the standard comparison fair?
• Oliver Williamson looked at the standard model, and drew
in a lower cost line to allow for scale benefits (a declining
long run average costs in the textbook language).
• Consider as he did what would happen to prices now, and
the deadweight ‘loss’ of monopoly.
• He used some simple arithmetic concerning demand and
cost parameters to suggest the following conclusion.
• ‘Relatively small cost reductions from beneficial scale
effects (say 10%) would outweigh allocative losses due
to full market power pricing’
• If scale effects are large there may even be net gains from
monopoly rather than Harberger type losses.
• D 5 in the lecture
On the other hand
• Remember organisational or x efficiency? If m
power creates opportunities to slacken off, costs
may creep upwards. And so offset some of this
good cost result.
• See this by doing the W diag again but factoring in
rising costs due to cost creep. If these outweigh
the benefits of scale then you are back to the
original Harberger loss or worse.
• However note that all is not lost! The ‘slackers’
get utility from slacking/ big offices etc and this is
in a way a ‘redistribution’ of total market surplus
not a total (or deadweight) loss.
• What if the rise in costs affects Fixed Costs but
not Marginal Costs? That is inefficiency strikes at
overheads and the like, not at incremental
production costs. A plausible scenario.
• Then the equilibrium price/ output doesn’t actually
change, and the cost increase is pure transfer
(from owners to employees). The social loss of
monopoly isn’t increased.
An ‘x’ efficiency conundrum
• Under highly comp conditions would employees/
managers of all firms really feel threatened by the loss of
employment and work at peak levels?
• If there is full emp in the competitive economy then the
loss of job isn’t much of a threat! Redundant resources get
picked up elsewhere! So will there really be universal x
efficiency in the competitive economy? Good question.
• Plus highly comp markets can be harsh and un
compromising and breed social resentment and defensive
reactions etc (read all about it in Zola, Dickens, Dos Passos
et al), and so damage social efficiency! What is the anti
globalisation movement on about? Is efficiency produced
by implied threat necessarily desirable?
7. The Coase critique
• Ronald Coase argued that the standard m model makes no
allowance for the role of product durability (use over
multiple periods). Some products are bought for
immediate consumption but many are not (houses for ex)
• The mon in general faces a credibility problem in getting
the mon price to stick. It has in a way an incentive to cheat
on its own monopoly price. Because once it successfully
sells the m quantity at the m price, it could in principle
earn even more by then undercutting this previous price.
• This is not a problem in a single period textbook model,
cause then there is no next period in which to cheat
yourself! But what if we consider the problem over time,
with multiple discrete selling periods?
• With a multi-period setting product durability
becomes an issue. Why?
• Because in the first period the m sells the m
quantity to those with the highest willingness to
pay for those units of output.
• But these folk still have the product in the next
period (or sell it second hand if they lose interest),
and those still ‘in’ the market by definition will
only buy at a lower price. So the m will need to
lower prices (cheat itself) in period two.
• If the m is likely to cut prices in the second period
who would buy in the first period when they can
hang on a bit for a bargain? Will some/ a lot of
people not postpone buying? Would we not be
influenced by the possibility of falling prices to
wait? Of course it would depend on how
‘impatient’ consumers were. Or technically, by
how much we ‘discount’ the future.
• Some people do time purchases of consumer
durables (autos, PCs, TVs) quite carefully (we
wait for Christmas sales for example!)
• That the need to lower prices over time (inter-
temporal price discrimination if you like) would
reduce m pricing power. Reduce the m ability to
capture m profits. Depending on how long a
period is. A day, a week, a year. And of course on
• So a mon in this situation can only seek to ensure
max profits now if it can commit itself to not
cutting prices later. Or if it leases rather than sells
its products outright (as Xerox, IBM, et al used to
do). See if you can figure out why.
• However as you will expect there is a counter argument. Durability
might work to the advantage of the m instead!
• The idea is now that the m acts tough and tells consumers it will set the
max price it can get for each unit (say houses) and wait until it gets a
taker. Then it will set a slightly lower price and wait until that unit
sells and so on. So it becomes a battle of wills, and if the m wins it
extracts lots of lovely consumer surplus.
• Could this work? Depends on things such as how long the m can
credibly afford to hold rather than sell its products. And consumer
patience. Think of this the next time you by a new CD or a DVD.
• * Pacman implies a strategy of ‘turning the tables’ on an opponent. Eg
an intended takeover target suddenly makes a bid for a putative
8. Countervailing power
• Standard m model assumes no countervailing
power on the other side of the market. ie buyers
are numerous and dispersed and can’t argue back.
• But what if they are not? What if the buyers are
few, or even only one (a monopsonist). It happens.
Supermarkets like Wal Mart and Tesco can take
on even powerful suppliers like Heinz, Coca Cola,
• In this case the monopolist’s profits will be reduced
because it now faces more powerful buyers who can
bargain rather than ‘take it or leave it’.
• The mon seller still wants to set the m price, but the buyers
demand a lower price (which max their profits) because it
or they have monopsony power (buying power)
• Now in fact there is no easy predictable (ie equilibrium)
outcome because it will depend on relative bargaining
power and credibility. The m wants to set the high m price,
the buyers demand the low monopsony price (see textbook
on how difficult it becomes to find the outcome now)
• This redistributes potential mon profit (consumer surplus)
back to the buyer side.
Balance of power?
• Switching costs. If the buyer becomes familiar with particular
suppliers this may raise costs in switching to another.
• Information costs. Often consumers find it expensive to be properly
informed. Car servicing, medicines, financial services, software. Power
is with the best informed.
• Economics of DIY. If the customer could DIY this constrains
suppliers. If suppliers could integrate forward it constrains buyers.
• Reputation. Being a Toyota supplier is a big deal, powerful suppliers
prepared to ‘pay’ for that. Buying Intel chips is a safe bet, customers
like Dell and Compaq pay for that. Airlines will only use a big name
engine supplier like RR. Harvard is the place for an MBA. Msoft for
• The customer’s customer. When your customer sells on you might
be able to influence its customers. Does Dell install Microsoft/ use
Intel because it likes them best or because it matters to customers who
will pay a premium for these things?
• Arises in this situation.
• It can be shown (bilateral monopoly case) that
vertical integration between two monopolies (one
buying what the other sells, say a generator and a
distributor of electricity) can produce social
benefits. Such as from reducing bargaining costs.
• Paradox here being that two mons are therefore
‘better’ than one.
9. Mon and innovation
• Does mon power really harm innovation (dynamic
effic) as Arrow’s famous model suggests?
• Recall first that this concerns the strength of the
incentive to innovate, ie it is about relative desire
to use or adopt a new idea (but not to look for it in
the first place!) It is intuitively appealing, but still
might be wrong-headed. Plus….
• It says nothing about relative ability to innovate!
Which may well be more important in practice.
• Maybe why George text says the model ‘strains
credulity’. Lets investigate a bit further.
Comp for the market v comp in the market
• An important distinction to keep in mind.
• What is the key issue in R&D/ innovation?
• Is it driven by competition already in a market, or by
competition for a market (which may not even exist yet)?
• Point? There may be a lack of competition IN a particular
market (telecoms 20 years ago) but that doesn’t stop
competition FOR that market by others investing in R&D.
• In pharmaceuticals patent protection often diminishes
competition in the market for a decade or so, but it cannot
prevent competition FOR the market continuing. Other
firms can (and do) keep investing in R&D and if one
comes up with something better, can then compete in the
market or itself become the dominant supplier.
• If we look at competition in innovative industries
we often see this. Several businesses or
entrepreneurs seek new products/ technologies.
Winning is nice for the winner, but not a guarantee
of sustainable dominance. The race can continue.
Successful innovators can seek to replace the
• Remember the words of Intel man, ‘only the
paranoid survive’. Meaning no matter how
dominant you are today you can disappear
• So should we worry a lot about the state of
competition in a particular market if there can be
competition for it?
• Innovators focus on creating new markets, not on beating up on the
competition. Successful companies do not focus on the competition
but on making competitors irrelevant by providing buyers with a
quantum leap in value.
• Value innovators use the consumer as the reference point not the
competition. Innovation is driven not by the technology but by
customer value. VI ask: are we offering consumers radically superior
value? Are our prices accessible to the mass of buyers in the market?
• Examples: Wal Mart, Ikea, CNN, SAP, Starbucks.
• Emphasis of these companies is not on patenting ideas but on the
combination and arrangement of elements (bundles) attractive to
consumers. And hard for competitors to match. Harvard BR, 2000,
Sloan MR 1999
Some characteristics of investment in R&D
• 1. It is very expensive and time consuming needing specialised
resources and facilities. Think of pharmaceuticals or electronics.
• 2. It is very risky: there is a lot of uncertainty involved, will you find
something, will it sell, will you recover dev costs?
• 3. Costs involved are open ended (once you start its hard to stop!) and
• 3. Investment is hard to evaluate, (what is the NPV?) so raising
finance is a problem. The bankers find it hard to fathom.
• 4. The output is knowledge, which is hard to protect, so hard to
capture all the rewards if successful. Some, or a lot, will leak out.
Despite patents. You might do the work whilst others reap the rewards.
• 5. It is difficult/ and so costly to organise and manage effectively
within the organisation (monitoring and controlling the process)
• 6. There may be significant economies of scale/ scope involved.
• Almost half of the profits of major drug businesses such as
GSKB (until recently this was four different firms) go into
development (£2 billion)! Indeed this has been the driving
force in the recent development of such giants. To ensure a
blockbuster every now and again a company has to bring
some new products to the market every year. Only a very
big business can achieve this.
• You must have a solid ‘portfolio’ of new drugs in the R&D
pipeline many of which are unlikely to make it. Average
R&D lead time is 12 years and costs £200m. The
minimum annual spend to stay in the race is put at around
• Sources: Deutsche Bank/ Lazard Freres.
Markets and R&D/ innovation
• What is likely to promote the ‘best’ level of investment in
R&D socially speaking?
• Note immediately that competitive markets driven by the
profit motive can’t produce the social optimal level
anyway (where msc = msb), so it is about the choice
between two structures (mon and comp) which are both
imperfect. Why? Because:
• The social benefit of R&D exceeds the private (eg because
of spillovers), and the social costs of R&D is less than the
private (eg because of taxes). So society will favour more
R&D than comp markets will promote.
• First, it is possible that too much competition in
searching FOR the next big winner could be
wasteful cause it might lead to excessive spending
(a la Posner). A lottery type effect (see earlier
slide on this). The thought of a big prize can
cause us to behave foolishly. The total amount
spent approaches or possibly exceeds the prize to
be won. Could competitive firms end up doing the
same thing looking for winners? Drug companies
for example. Would that be socially useful?
• Second, possibly too much competition will
reduce R&D because it reduces the ability to
finance risky investments. Capital suppliers find it
hard to figure the probabilities. And find it hard to
monitor effort/ performance. Thus, R&D is in
practice largely financed from business profits.
But highly competitive markets don’t allow for
above normal profits. So how can firms finance
R&D? Some economists have argued that for this
reason market power will encourage innovation
rather than harm it.
• Third, too much competition may reduce
R&D efforts and innovation because of
problems with appropriability of rewards.
Even if you succeed how can you stop fast
imitators? Look at Sony! At how quickly
its innovations are copied. It has to run
very fast to stay ahead. Will it get fed up?
Monopolist presumably has less to worry
about here so stronger incentives to spend.
• Fourth: mon incentive to innovate may be stronger than
Arrow allowed for because in practice it knows that if it
doesn’t innovate its current profits can eventually be
eroded by an innovating entrant. This is R&D as a
protection policy. If the monopoly thinks forward it must
see this. In fact it can be shown in principle that a
monopolist has a greater incentive to innovate to sustain
itself than a potential entrant has to innovate and then
compete with the monopolist.
• Hence again the man who ran Intel, a firm with a lot of m
power: ‘only the paranoid survive’. Or the boss of GE
who urged his executives to ‘destroy the business’ before
someone else did.
• Fifth, a monopolist may even over invest in
R&D simply because it can afford to. It has
the money to indulge itself and to make sure
it stays ahead of the game. Managers
especially may be prone to this because they
gamble with someone else’s money. The
shareholders bear the risks of failure,
managers get the glory for success.
Managers can lose a career to a successful
entrant, shareholders just lose money.
• Sixth, innovation might be best served by a
moderate degree of competition amongst strong
rivals rather than intense comp. Oligopolists as
we see below soon learn that price competition is
destructive all round and will try to cooperate.
This possibly has the effect of deflecting
competitive efforts to the less destructive
innovation (or advertising) where firms can get an
edge which is more difficult for others to quickly
• Finally, too much competition might harm the realisation
of significant economies of scale&scope in R&D process
• Scale as we have seen is likely to be vital when
development costs are big. Dev costs are paid upfront and
have to be amortised over future output. The bigger the
better, because of the pricing implications of cost recovery.
Small comp firms just couldn’t do it. (what about
collaboration to overcome this disadvantage?)
• And scope? Portfolio effects exist. Pursuing just one idea
is very risky! But having a portfolio of ideas on the go
means things might balance out. Some you win many you
lose. But a big winner compensates for all the losers. Like
a share portfolio, the winners compensate for the duds.
This makes money easier to raise in principle. (Although
note, a financier could in theory invest in a portfolio of
small business R&D).
The Schumpeter hypothesis
• A combination of some of the above arguments
was in fact first put forward in the 1940’s by
Joseph Schumpeter and much of the subsequent
debate in the area has referred back to his ideas
(and of course Arrow’s).
• These were to the effect that technological
dynamism was in fact best served by big business
with a good degree of market power (not
necessarily monopoly however). As we will
discuss later these views have been the subject of
much empirical research and testing.
10. View of competitive process
• Finally, The mainstream textbook view of
competition and the comp process is
arguably very narrow. PC & MC models
basically, with even the latter tagged
harmful. But is that it really?
• There are other ways of looking at the
world. Broader, more dynamic, more
realistic, overlapping views of competitive
The Austrian view of competition
• According to this school of thought the textbook focus on
‘industry’ structure is misguided. It is the FIRM alone that
matters, because ‘industry’ structure is a consequence of
how firms compete not vice versa
• Market structure is an outcome of competition between
firms, the search for competitive advantage, not a
determinant. It is endogenous not exogenous. Firm
actions and relative success determines both market
structure and average profitability. The idea that market
structure drives profits is thus spurious. Back to this later
under evidence. Firms are unique & heterogeneous. And
everyone is competing with everyone else for
• See for ex Hill/Deedes, J of Management Studies, 1996
• The two views are of course not mutually
exclusive. Firm actions can obviously
affect market structure outcomes, and
market structures can influence firm
actions. There is interdependence between
the two rather than the one way causation of
the textbook S-C-P model. This seems
John Kay’s case for competition
• Is much better than standard textbook case.
• In ‘The truth about markets’ (2002) book Kay argues that the case is
really about how competition encourages the variety of experiments or
plurality of approaches and is ultimately more responsive to consumer
needs. Monos finds it hard to promote plurality of thinking and are
less responsive to needs. See esp his chap 30 on disciplined pluralism.
Policy should promote pluralism not some idealised state of
competition. Pluralism is about encouraging and making use of new
info to innovate in value. So if one firm earns ‘excess’ profits it is not
a matter of concern as long as others are at least allowed to seek to
Competition is a process
• Competition is a process (not an event) arising
from the on-going desire of organisations to
search for ways of creating and capturing value.
• Whenever one business identifies and exploits a
profitable opportunity it demonstrates its potential
to others who seek ways of grabbing a piece of the
• PC’s, memory chips, selling on the internet,
mobile phones, budget airlines, ….
The nature of competition
• Firms compete in different ways, or different
combinations of ways, which change over time.
• Price competition
• Marketing/ advertising/ differentiation
• Product development/ quality improvements
• Product range (esp retailing)
Creating ‘competitive advantage’
• Cheaper (lower costs) producer: ?
• Better (superior perceived quality): ?
• Newer (more innovative/up to date/fashionable): ?
• Faster (speed to market): ?
• More desirable/ distinctive (successful branding):?
• Better reputation: ?
• First mover: ?
• Provide your own examples of firms that compete
successfully on this basis.
• Imitation/ replication: good ideas, products, services get copied/
imitated rapidly(often even patents aren’t much of a protection), eg
Amazon, Easy Jet….
• Commodification: once innovative products eventually tend towards
standardised commodities, eg microprocessors, most pharmaceuticals,
ball point pens….
• New entry: first mover profits are dissipated by attackers, new
entrants, eg photo-copiers, mobile phones, ..And NB new entrants need
not be ‘new’ businesses.
• Technological change: competition can appear from unexpected
directions. On-line degrees, internet bookshops/ banks, e mail, ….
• Fragmentation: specialist firms begin to cherry pick the most
valuable segments: postal services, consumer electronics, boutique
• Deregulation/ liberalisation: established monopolistic positions
(often granted by state fiat) are opened up, eg airlines, water, postal
services, electricity, telecoms….
• Globalisation: increasing penetration of national markets by
international firms: autos, telecoms, financial services, electricity.
• Information (and communication) costs: are falling as a result of
technology. Increasing price visibility and value comparability. Look
at car buying for example, or bookselling, or electrical goods, or travel.
• Integration: suppliers integrate forward (Msoft into game consoles),
customers integrate backwards (Dell into producing peripherals?)
• Other factors at work: More demanding, better informed, consumers
(What computer, What hi fi etc).
Competition for the market
• Innovators focus on creating new markets, not on beating up on the
competition. Successful companies do not focus on the competition
but on making competitors irrelevant by providing buyers with a
quantum leap in value.
• Value innovators use the consumer as the reference point not the
competition. Innovation is driven not by the technology but by
• VI ask: are we offering consumers radically superior value? Are our
prices accessible to the mass of buyers in the market?
• VI uses target pricing to build volume and target costing to ensure
• Examples: Wal Mart, Ikea, CNN, SAP, Starbucks.
• Emphasis of these companies is not on patenting ideas but on the
combination and arrangement of elements (bundles) attractive to
consumers. Harvard BR, 2000, Sloan MR 1999
Market space v market share
• Competition is now about max. your share of consumer
spending (market space) not specific product market share.
• Seeking to ensure longevity (loyalty), depth, breadth, and
diversity of spending.
• BP for example seeks to sell ‘energy solutions’ not just oil.
Unilever no longer just sells cleaning products but markets
cleaning services/solutions. Lego embraced the possibility
of computer games which had threatened its traditional
business. Virgin offers a comprehensive door to door
service not just a flight. Ford is no longer just about
‘pushing the metal’ but total product/ service packages.
• Sloan management review, 2000
• Is really the antithesis of competition as we know it. So
referring everything to the idealised model is misleading.
Competition in practice IS about seeking advantage by
methods such as product diff and development, innovation,
quality improvements, ….not just price. Markets
conforming to the idealised model are rare. A world like it
would perhaps not be very perfect at all. In any case comp
doesn’t have to conform to the perfect model to be
beneficial. Otherwise capitalist economies wouldn’t be
Sum up on m power
• So we have it. The textbook model of mon is
based on a set of quite extreme, possibly dubious,
assumptions which ‘strain credulity’ and which
weaken the universality of the naïve ‘harmful’
result. We do not seek to show m is good, just
that it may not be, on balance, as ‘harmful’ as the
mainstream two dimensional model suggests.
• But this is not end of story, next we should
consider oligopoly markets, what happens
between the two extreme models. Then of course
look at the empirical evidence on these issues.