Lecture 2
Industrial organization
Emmanuel Frot
Sciences-Po Paris
Introduction
 We reviewed last week the concepts from microeconomics
required for this course
 Today, we focus more specifically on industrial organization and
on the main models it uses to study markets
 The outline of this lecture is
– Perfect competition
– Monopoly
– Oligopoly models
– Competition policy
2
Perfect competition
 Perfect competition is a reference model in economics
 Assumptions :
1. Atomicity: firms cannot influence prices, they are price-takers
2. Homogeneity: goods are perfectly identical, such that consumers
switch suppliers if there is a price differential
3. Perfect information: firms have all the information they need to
maximize profits
4. No barriers to entry or exit: firms can freely enter and leave
 Typical examples are agricultural products with many small
suppliers that can only sell at a given market price
3
Perfect competition equilibrium
 Under these assumptions, the market reaches an equilibrium
characterized by the equality of price and marginal cost
 Each single firm produces output such that this equality is
satisfied
 What is the intuition behind this result?
– If price was larger than marginal cost, then firms would make
profits on the last unit sold: they should produce more output,
and that will decrease price
– If price was smaller than marginal cost, then firms would make
losses: it should not produce the last unit and therefore should
produce less; quantity falls and price increases
– The equilibrium, when the firms have no incentive to change their
output, is when price is equal to marginal cost
4
Perfect competition
 In addition, firms are making zero profit
 The model relies on strong assumptions
– No market power, homogeneous goods, perfect information, no
barriers to entry, etc.
 In practice, all these assumptions are rarely satisfied
simultaneously
 Why do economists consider this model as a reference ?
5
Why the perfect competition model is useful
 Under perfect competition, the market reaches an equilibrium
that is efficient from a welfare point of view
 State intervention is therefore useless on such a market
 This results is helpful to delimit the boundaries of government
intervention
 If the assumptions of the model are satisfied, then there is no
reason for an intervention
 Otherwise, it may be appropriate
6
Why the perfect competition model is useful
 It serves as a benchmark to understand why markets are not
competitive
 It helps in identifying market failures and in designing an
economically justified market intervention
 For instance
– No market power → an abuse of dominance is economically
harmful
– Price taking → a price cartel is harmful and should be condemned
– No barriers to entry → an exclusionary practice should be
condemned
7
Perfect competition model: applications
 Markets usually do not fit into this model
 However it is also useful in practice to understand market
forces and firms’ strategies to avoid its outcome of zero profit
 The assumptions of the model basically show you the
conditions that lead to a very competitive market, and hence
little profitability
– In other words, for firms to enjoy significant profits, they must
devise strategies that violate these assumptions
8
Perfect competition : application to flat-panel displays
Source: The Economist
 Between 2004 and 2010
– Sales by volume of LCD flat-panel screens have increased tenfold
– Prices have fallen by 75%
Source: DisplaySearch
9
Perfect competition model: applications
 Consumers benefited from this evolution, but manufacturers
are struggling
– Demand is high: 220m flat-panel televisions in 2011, representing
$115 billion
– Many more displays in smartphones, tablets, etc.: 2.5 billion
screens worth $100 billion
– Between 2004 and 2010, manufacturers lost a combined
$13 billion
Year-on-year change
in average price for
LCD TV and PDP TV
(plasma TV)
10
Source: DisplaySearch
Perfect competition : application to flat-panel displays
 When production began to take off in 2002, the industry was
profitable
 In 2004, Samsung and Sharp were making 10-15% profit margins
– Note that LCD makers colluded between 2001-2006, which may
explain the comfortable profits
– Six of them were fined €648 million by the EC in 2010
– Since 2008, eight companies have pleaded guilty in the US and paid
more than $1.4 billion in fines. 22 executives have been charged.
 That changed after 2006
– Prices fell by 80% between 2004 and 2008
– Costs declined by 50%
 How can we explain this quick evolution from profits to low or
negative margins?
11
Perfect competition : application to flat-panel displays
 There is little differentiation between products
– Firms tried to differentiate with larger screens, higher image
quality, interactive features like Sony’s online services but without
much success
 Capacity has increased to reap economies of scale
– Glut of displays on the market
– A manufacturing facility is expensive but new entrants build giant
plants that could increase the industry capacity by up to 30% at a
stroke
 Entry costs are quickly decreasing because of technological
progress
12
Perfect competition : application to flat-panel displays
1.
Industry with homogeneous goods
2.
Low barriers to entry
3.
Overcapacity that makes firms price-takers
 This is relatively close to perfect competition
 The outcome is zero-profit. As of January 2012:
– Sony loses $45 with every TV set it sells
– Panasonic’s television unit has not made any money for four years
 This is set to continue as Chinese factories’ production capacity
doubled in 2012
13
Perfect competition : application to flat-panel displays
14
Source: DIGITIMES Research
Flat-panel displays: conclusion
 The industry in itself is not perfectly competitive
 But it fits many characteristics of the model
 The point of the example is also to introduce models where
strategies of differentiation are used to avoid the perfect
competition outcome
15
Imperfect competition models
 Most markets do not correspond to the perfect competition
model
– Firms often have at least some market power
 Models that describe this reality are also needed : these are
models of imperfect competition
 There are many of these models but we only focus on the most
widespread
16
Monopoly
 Monopoly is the opposite extreme of perfect competition
– Instead of having a very large number of firms, there is only one
 A monopoly is not a price taker
– It recognizes it can use its market power to influence prices
 This ability to choose prices has direct consequences on
consumer welfare
17
Monopoly and perfect competition equilibrium
 Perfect competition
– Price equals marginal cost
– A firm cannot unilaterally increase its price as its competitors would
sell to its consumers
 Monopoly
– Price is above marginal cost : no competitor can undercut its price
– However the monopoly does not increase its price indefinitely
– Two effects must be taken into account when price increases: (i)
profits increase as each unit sold brings in more money, (ii) profits fall
as demand is lower at higher prices
– The monopoly chooses its price such that these two effects exactly
compensate each other; that occurs when marginal revenue is equal
to marginal cost
18
Monopoly equilibrium
Prices, costs
Marginal cost
Demand
Marginal revenue
19
Quantity
Monopoly and perfect competition equilibrium
 Monopoly leads to higher prices and lower quantities than
perfect competition does
– Start from the competitive equilibrium price = marginal cost
– If the monopolist decreases output, it makes profits on the last
unit sold
– Unlike a firm on a perfectly competitive market, it does not induce
competitors to increase output
– The monopolist is able to extract this rent
– On a competitive market, this strategy fails because when quantity
falls, each firm has an incentive to increase output to reap profits.
20
Monopoly and perfect competition equilibrium
 Monopoly negatively affects consumers
 This benefits producers
 Overall, the society is made worse off
 Higher prices have two effects on consumers
– Some keep on buying the good but pay more: that’s a transfer
from consumers towards the firms
– Some stop buying : both consumers and firm lose, this is a
deadweight loss
21
The inefficiency of monopoly
Prices, costs
Transfer from
consumers to
the monopoly
Marginal cost
Deadweight loss
Demand
Marginal revenue
Quantity
22
Monopoly and perfect competition equilibrium
 The transfer is equivalent to redistributing money to the firm at
the expense of consumers
– That is a zero sum game from a financial point of view
– Depending on how the society values firms relatively to
consumers, it may consider that this represents a loss or a gain
from a welfare point of view
 The deadweight loss is the damage to the economy
 A monopolist is inefficient
– If it produced more, people would be willing to pay more than
what it costs
– However the monopolist does not want to produce this extra
output, because it would decrease prices on all the units sold
23
Monopoly: numerical example
 Assume a monopolist produces 100 units, at a price of 3
 Assume marginal cost is constant and equal to 1, there are no
fixed costs
– Profits are 100*3-100*1 = 200
 Assume consumers are willing to pay 2.9 for this additional unit
 Since consumers are willing to pay more than the marginal cost,
it would be economically efficient to sell them the additional
unit
24
Monopoly: numerical example
 If the monopolist produces 101 units, its profits are 2.9*101101*1=191,9
– The monopolist does not produce the additional unit since 100
units give it profits of 200
 Even though the additional unit brings profits, it forces the
monopolist to lower its price on all 100 units it used to sell at a
price of 3
 On a perfectly competitive market, since there is money to
make on the additional unit, a firm will increase output
– That will ultimately lead to a price of 1 (marginal cost)
25
Monopoly : pricing rule
 It is possible to analytically derive the pricing policy of a
monopoly
𝑝 − 𝑀𝐶 1
=
𝑝
𝜀
 Remember that in a perfect competition equilibrium, price is
set equal to marginal cost (MC)
 The formula shows how far the monopoly price p is from the
perfect competition price MC
 ε is the price elasticity of demand : it measures how responsive
demand is to a price change
26
Monopoly : pricing rule
 For instance, an elasticity of 2 means that a price increase of 1%
decreases demand by 2%
 If the elasticity is larger than one, demand is said to be elastic
– Demand changes more than proportionately to a price change
 If the elasticity is smaller than one, demand is said to be
inelastic
– In the limit, if ε=0 demand does not respond to price changes
 The monopoly pricing rule states that the larger the elasticity,
the smaller the difference between the monopoly and perfect
competition prices
27
Monopoly pricing rule : example
 For instance, with a marginal cost equal to 1, the perfect
competition price is 1
28
Elasticity
Monopoly price
1.1
11
1.5
3
2
2
3
1.5
4
1.33
5
1.25
10
1.11
Monopoly and demand elasticity
 Intuition behind the pricing rule
– A monopolist takes two forces into account : (i) higher prices
generate more profits but (ii) they decrease sales
– If demand is very elastic, (ii) predominates and the monopolist is
not able to increase its prices by a large amount compared to the
perfect competition price
– If demand is not elastic, consumers do not react to price changes
and (i) predominates. The monopolist can extract a lot of income
from consumers
 Regarding the inefficiency of the monopoly, it is larger when
elasticity is small
29
Effect of a monopoly: airline liberalization
 Example of the entry of the airline People Express in the US in
1984-1986
– Lower prices and higher quantity the year of entry
30
Source: M.D. Whinston and S.C. Collins, Entry, Contestability, and Deregulated Airline Markets: an Event
Study Analysis of People Express, NBER Working Paper, 1990.
Oligopolistic competition
 In practice, markets are characterized by a few firms selling
substitutable goods
– The monopoly framework is not relevant
– Neither is the perfect competition model
 Oligopolistic competition refers to this common situation
 Although located between the extremes of perfect competition
and monopoly, it uses different concepts
31
Oligopolistic competition
 In the monopoly and perfect competition cases, firms face a
rather passive environment
– A monopolist does not have any competitors
– Under perfect competition, price is completely determined by the
market
 In an oligopoly, how firms react to the decisions of their
competitors will be a key ingredient of the model
 Firms are interrelated and their actions are determined by
those of their competitors
32
Bertrand price competition
 Bertrand competition is a simplified oligopoly model
– Firms sell perfectly identical goods
– They have identical production costs
– They are not constrained in their production capacity
– They choose prices simultaneously and independently
 Under these assumptions, the market equilibrium is the same
than under perfect competition
– Price is equal to marginal cost
33
Bertrand price competition
 The intuition is the following :
– Suppose prices are higher than marginal costs: firms make profits
on the last unit sold
– One of them has an incentive to undercut its rival to capture its
demand
– If this new price is higher than marginal cost, then this reasoning
applies again
– Firms eventually stop this price war when price is equal to
marginal cost : a lower price would imply losses on the last unit
 This result is striking: an oligopoly with only two firms can reach
a perfect competition equilibrium
34
Bertrand price competition
 The assumptions of the model are quite unrealistic in most
situations
– Firms usually do not sell identical products
– They face capacity constraints
– They do not have the same production costs
 Without any of them, the result breaks down and price is not
equal to marginal costs
 But again, the point of the model is to underline the economic
forces that lead to this outcome
35
Bertrand price competition - example

Pizza in New York (from a 2012 NYT
article)
– A pizza parlor is selling its pizza slice at
$1.5
– Another opens close by, selling at $1 per
slice
– The first parlor also cuts its price to $1
– A third one opens next door to the first
– The first decreases its price to 79 cents
– The others cut it to 75 cents
– The first also goes down to 75 cents
– They are now considering a price of 50
cents : “We’re never going back to $1.
We’re going lower. We may go to 50
cents. I want to hit him. I want to beat
him.”
36
Bertrand price competition
 This simple model underlines that competition can be fierce
even with a very limited number of firms
 Its assumptions show under which conditions this is likely to
happen
 As shown by the example, this corresponds to some real-life
situations
37
Cournot competition in quantities
 Competition between firms is not only about prices
– Firms compete on quantities, investments, R&D, etc.
 Instead of choosing prices, firms strategically choose their
quantities
 The model is more relevant if quantity is interpreted as production
capacity
 That is the case in sectors where price is globally fixed
– Example of refining in the oil industry: capacity is a strategic variable,
while price is determined on the world market
 More generally, the Cournot model is relevant for markets where a
variable (capacity, R&D) influences how firms then compete in
prices
38
Cournot competition
 Unlike in the Bertrand model, a Cournot duopoly does not lead to
prices equal to marginal costs
– And firms make strictly positive profits
 The Cournot equilibrium depends on the number of firms in the
market
– The larger the number of firms, the closer it is to the perfect
competition equilibrium
– The lower the number of firms, the closer it is to the monopoly
equilibrium
 Cournot therefore offers a continuity from monopoly to perfect
competition
 It grasps the intuition that competition intensity increases with the
number of firms
39
Bertrand vs. Cournot
 How shall we determine whether a market is characterized by
competition in quantities or prices?
 It seems firms virtually always compete in prices
 These two models describe two types of markets
– The Bertrand model corresponds to markets where costs are
relatively constant and capacity is not an issue. Prices then
become the key strategic variable
– The Cournot model corresponds to markets where costs are
strongly increasing, for instance because of capacity constraints or
of having developed necessary techniques through R&D. The key
strategic variable then becomes capacity/knowledge
 This distinction underlines that some industries are more
focused on prices than others
40
Bertrand vs. Cournot
 Actually in many sectors, capacity is difficult to adjust
– In wheat, cement, steel, cars, and computer industries, it is easier to
adjust prices than quantities
– Example from a salmon farming merger case (Marine Harvest/Pan
Fish): « un marché sur lequel les prix s’imposent aux entreprises en
fonction des quantités disponibles (concurrence à la Cournot) »
(Conseil de la Concurrence, avis 06-A-20)
– The Cournot model is a good approximation
 Sometimes capacity is not an issue
– In software, insurance, and banking industries for instance
– In these industries, it is costless to produce more output
– Consider also the encyclopedia/music market : marginal costs are
virtually nil, and online distribution has triggered a fierce Bertrand
competition
41
Product differentiation
 In many sectors, firms compete in prices and do everything they
can to avoid the Bertrand/perfect competition outcome
– Homogeneous products lead to low prices and low profits
 A classic strategy to avoid it is differentiation
– It consists in introducing differences in products to restore some
market power
– If products are not homogeneous, a price increase will not result
in all consumers switching to a competitor as some are likely to
value the specific characteristics of the product
42
Horizontal differentiation
 There are two types of product differentiation: vertical and
horizontal
 There is horizontal differentiation when consumers have
distinct preferences: for a given price, they do not buy the same
good
43
Horizontal differentiation
 Firms choose the characteristics of their goods
– For a car: type of engine, colors, design, etc.
 Consumers buy the good that is closest to their preferences in
the product space
– It is “costly” for a consumer to “move” in the product space : one
does not want to buy a product that does not fit one’s preferences
 This differentiation is common in many markets
– It softens price competition to avoid the Bertrand outcome of low
prices (and profits)
 However, it is not always optimal for firms to adopt maximal
product differentiation
44
Horizontal differentiation and firm strategy
 Firms take two effects into account when they design their
products
– A margin effect: an isolated product, with very specific features,
will be highly praised by a very small set of consumers. It will enjoy
a quasi-monopoly on these consumers, and so will make high
profits. On the other hand, it will sell few units.
– A market share effect: sales can be increased by designing a
product enjoyed by many consumers. That implies being in direct
competition with other firms selling similar goods, having a larger
market share but at the same time a lower market power and
lower profits
 When consumers have very specific preferences (it is costly to
move in the product space), the first effect is predominant:
firms differentiate as much as possible
45
Horizontal differentiation and firm strategy
 Otherwise, the market share effect is predominant and firms
sell similar goods
 That occurs when most consumers have similar tastes or do not
mind changing products
– Differentiation in laundry detergents tends to be quite low for
instance
 It also occurs when there is no price competition, hence no
margin effect (because there is no price or it is regulated). In
that case, it is optimal to be where the demand is:
– TV shows
– Political platforms
46
Vertical differentiation
 Consumers agree on the ranking of products and would all buy
the same good if they could
 However, income differences prevent them from doing so
47
Vertical differentiation
 Vertical differentiation models show that the number of firms
on a market is usually limited, even when the market is large
– This contrasts markedly with horizontal differentiation models
where large markets are characterized by more firms
 Vertical differentiation can result in a market with a single firm
operating in equilibrium
– If most consumers can afford high quality, an entrant may not be
able to challenge the incumbent
– If it sells at a lower quality, consumers will stick to the high-quality
good, in particular as its price will go down after entry
– If it sells at the same quality, price competition will make profits go
to zero and will make entry non profitable
48
Summary of competition models
Monopoly
price
Marginal cost
Perfect
competition
49
Bertrand
price
competition
Cournot
quantity
competition
Differentiation
Monopoly
Business case: the coffee industry

The coffee industry can be used to illustrate the economic forces of
competition and differentiation
– Sources: articles by John M. Talbot and from The Economist

A few historical facts:
– Coffee introduced to Europe in the early 1600s
– Plantations spread in European colonies: a Dutch botanist took seeds from Java
to Amsterdam and grew trees there. Seedlings were then sent to Surinam by the
Dutch and to Martinique by the French. Surinam seeds were then sent to Brazil
in 1727
– The trees from Martinique spread to the Caribbean and the rest of Latin
America
– Most of the arabica coffee trees now growing in Latin America are direct
descendants of a few seeds from Java
– Around 1900, seeds from the Caribbean were planted in East Africa
– Robusta coffee spread through Dutch and French colonies (Central and West
Africa, South and South East Asia)
50
Coffee: spread throughout European colonies
51
Source: Natural History Museum, London
Coffee trade
 One of the most important agricultural exports from developing
countries to developed countries
 More than 70 countries export coffee
 However, the top 5 producers represent a large share of global
exports
52
Coffee trade
1999-2000
2012-2013
Brazil
23%
Brazil
27%
Others
32%
Others
45%
Vietnam
12%
India
4%
Indonesia
5%
India
5%
53
Colombia
10%
Source: International Coffee Organization
Colombia
7%
Vietnam
20%
Indonesia
10%
Coffee trade: imports
 In 2012-2013
– The EU accounted for 65% of imports
– The US represented 24% of imports
 Four multinational conglomerates (Nestlé, Kraft, Procter &
Gamble, Sara Lee) bought 40% of the word’s green coffee in
2001
 They use blends
– That allows them to substitute coffees to maintain the overall taste
of the blend while purchasing the cheapest coffee available
54
Coffee trade: exports
 Coffee exports are very important for some least developed
countries
 They represent a large share of total exports in some countries
(66% in Uganda, 63% in Burundi, 54% in Ethiopia, 52% in
Rwanda, 36% in Colombia) (average over 1962-2010 figures, Source: IMF)
 It plays a key role in rural development and has an important
impact on the incomes of many small farmers
 Coffee production employs around 20-25 million people in the
world
– Many growers are very small (Brazil is the exception)
– For instance in Colombia more than 500 000 families grow the
beans
55
Coffee production
150 000
140 000
*1000 bags
130 000
120 000
110 000
100 000
90 000
80 000
1990
56
1992
1994
1996
Source: International Coffee Organization
1998
2000
2002
2004
2006
2008
2010
2012
Types of coffee
 Four broad types, from highest to lowest quality
– Colombian milds, produced in Columbia, Kenya, Tanzania
– Other milds, produced in Latin America, India, Papua Nea Guinea
– Brazilian arabicas, produced in Brazil, Paraguay, Ethiopia
– Robustas, grown in African and Asian countries
57
Downward concentration and barriers to vertically
integrate
 Green coffee is sold by producers to roasters (multinational
firms)
 Growers do not roast and package coffee on a large scale
– They lack the size of the large roasters and the financial resources
– Roasted coffee goes stale quickly such that it is difficult to ship
over long distances
– To reproduce the blends, they would have to import coffee
58
Price instability
 Supply is subject to bumper crops and weather fluctuations
 In addition, coffee is a tree crop
 It takes three to five years after planting to begin bearing coffee
 A low supply in a year because of bad weather conditions increase
prices
– That encourages planting (market entry)
– The next 3-5 years, supply is constant
– After 5 years, the new trees start producing,
there is a glut of coffee on the market
– Prices go down
– Growers make losses
59
Example of price instability
 In July 1975, a killer frost struck the coffee growing regions of
Brazil
– Brazil production in 1976-1977 fell to 30% of its 1975-1976 level
– Prices skyrocketed
 Other growers planted trees
 In 1980, prices fell as the trees planted during the 1976-77
boom began to produce
60
1975 Brazil frost
61
Source: J.M. Talbot, Information, Finance and the New International Inequality: the Case of Coffee,
Journal of World-Systems Research, VIII, 2, 2002
Coffee industry characteristics
 Many small growers with no market power and low barriers to
entry
 A tight group of buyers with market power
– These two points imply growers are price-takers, they cannot
influence prices
 A rather undifferentiated product for most of the market
– Large buyers can easily substitute
 A (relatively) homogeneous good, with many small suppliers:
the industry is quite close to a perfect competition market
 That implies producers will have a hard time making profits
62
Consequences for producers
 Given the economics of the industry, suppliers could opt for two
strategies
1. Avoid the perfect competition equilibrium by coordinating on
quantities
2. Differentiate
 The first solution actually drove the industry for many years
before collapsing
– In terms of economic models, that means moving from perfect
competition to an oligopoly/monopoly model
 The second solution is now arising
– In terms of economic models, that means moving from perfect
competition to a differentiated good model
63
The International Coffee Agreements (ICA)
 Producing countries organized in the 1950s to regulate the
market
– At the end of WWII, consumption increased in Europe and Japan
– Prices went up
– Coffee production expanded because of low barriers to entry
– By the late 1950s, production exceeded demand and prices fell
– Hence the need to regulate the market
 Interestingly, the mechanism described above matches the
description of a competitive market
– Prices increase → profits rise → attracted by profits new suppliers
enter the market → supply increases → prices fall → profits are
back to their initial level
64
The International Coffee Agreements (ICAs)
 The ICA was an agreement between coffee-producing and
coffee-consuming countries signed in 1962
– System of quotas to keep prices within an agreed-upon range
– Stocks were used to smooth out price fluctuations
– For instance, a bad year would push prices up but stocks would be
put on the market to increase supply and lower prices
 The ICA worked for coffee as OPEC still does for oil
 ICA members used to represent over 99% of world exports
 Four ICAs existed between 1962 and 1989
 The last agreement collapsed in 1989
65
Political motivations for the ICA
“A free market economy in coffee should perhaps be an ultimate
Goal. But the reality is that many of the developing countries of the
World which depend so much on coffee cannot now cope with the
severe economic dislocations which are caused by wide swings in the
price of their principal revenue and foreign exchange earner. (…) The
coffee agreement (…) serves our foreign policy objectives of building
strength and freedom in developing areas of the world while
protecting the American consumers. (…) the key question is whether
it is in the U.S. interest to allow these countries, a large number of
them, to go through the wringer, as it were, at a time when
populations are doubling every 18 to 20 years and take a chance that
they would stay on our side of the curtain which divides the free and
the Communist world.”
Hon. Thomas C. Mann, Executive Hearings on S 701 before the House Comm. on Ways and
means, 89th Congress (1965), quoted in “Can cooperation Survive Changes in Bargaining power ?
The case of Coffee”, Barbara Koremenos, UCLA
66
Getting closer to monopoly: the ICA
 Without the ICA, a price increase would have resulted in
overplanting
– Each producer has an incentive to produce more to reap profits on
the marginal unit supplied
– Suppliers have a collective incentive to limit supply, but not an
individual incentive
– That drives profits down
 With the ICA, coordination prevents this behavior
– Quotas imply that the additional supply will not be sold
– Like a monopolist, even though the marginal unit brings profits,
the cartel refrains from increasing production to maintain profits
high
67
The end of the cartel
68
Trying to revive the cartel
 In April 2001, the price of coffee reached very low levels
 The Association of Coffee Producing Countries (ACPC) met in
May to attempt to push prices up by holding back exports
 This failed and prices remained low
69
Trying to revive the cartel
 The ACPC wanted suppliers to eliminate low-quality production
 But in 2001, the industry had changed dramatically
– Asian countries, and in particular Vietnam, Indonesia and India
had entered the list of top-5 exporters
– Vietnam produces cheap, low-quality coffee
– These countries are not members of the ACPC
 The key difficult in a cartel is stability
– Each member has an incentive to break the rule
– When ACPC members cut back their exports, Vietnam simply
increased them
70
Differentiation
 To avoid the zero-profit outcome of perfect competition, firms
can differentiate to gain some market power
 That occurred in the last decade
 Colombia invested in technical advice, quality control and
branding
– Colombian coffee attracts a 10% premium
 Jamaica sells its Blue Mountain coffee at a high price
 Organic and fair-trade coffees sell at higher prices
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Differentiation
 Producers start to market their single-estate coffee as blends make
differentiation ineffective
 By selling a brand instead of a commodity and focus on marketing,
it is possible to bypass the middlemen
 Despite these efforts, the industry is still suffering from oversupply
– Brazilian and Colombian farmers invested to boost production in
response to high prices in 2011
– That added to supply
– Prices have already begun to fall: the composite price was 231 cents
per pound in April 2011; it was 166 in August 2013
– Coffee growers blocked roads in Colombia in March 2013 to protest
against low prices
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Coffee industry: conclusion
 Economic forces in the coffee growing industry make it a low
profits sector
 This has dire consequences for many farmers in developing
countries
 Simple economic arguments are sufficient to understand the
industry
 They also point at the possible solutions
– Regulate prices through a cartel of producers: this also has
consequences in terms of welfare if prices are artificially high
– Differentiate: sell coffee more like fine wine than like a commodity
– Bypass the conglomerates with market power
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Competition policy
 The goal of competition policy is to protect consumers
– It does not protect competitors, but consumers
– It focuses on anticompetitive practices or market structures that
negatively impact consumers’ welfare
– It ignores inequality or redistribution : a well-functioning market
allows redistribution if necessary
 The key result at the core of competition policy is that the
competitive outcome is best for consumers
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Competition policy
 There are many obstacles to well-functioning markets :
– Non-tradable goods : air quality
– Public goods : national defense
– Goods that cannot be provided through the market : rail
infrastructure, power grid
– Information asymmetry, externalities, etc.
 Competition policy focuses on firms’ strategic behavior
– Collusion, barriers to entry, etc.
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Competition policy
 Competition policy takes two main forms:
– The control of mergers to avoid market structures that are
detrimental to competition
– The control of anticompetitive practices to detect and penalize
behaviors that hinder competition
• Abuse of dominance
• Collusion
 These will be covered in more details in lectures 4 and 5
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Assessment of the degree of competition
 Competition authorities very often have to assess the degree of
competition on a market
– This is always the case in abuse of dominance cases and mergers
– Many conducts are deemed anticompetitive only if a firm enjoys
market power
 The rationale is related to the efficiency argument of
competitive markets
– If competition is strong enough, then the equilibrium is efficient,
otherwise we should worry about inefficiencies
 Competition authorities use various tools to assess market
power
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Number of firms
 The Cournot model suggests that more firms lead to an
outcome closer to the competitive equilibrium
– Competition authorities will be especially wary of markets with
one or two dominant firms
 Correspondingly, market shares are also a key indicator of
market power
 Using, the Cournot model, one can show that
𝑝 − 𝑀𝐶 𝑠
=
𝑝
𝜀
 Where s is the market share of the firm
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Market share
 This formula indicates that the gap between the price and the
perfect competition price (marginal cost MC) increases with the
market share of a firm in a Cournot model
– The larger the firm in an oligopoly, the larger its deviation from the
competitive outcome
 That makes market shares good predictors of market power
– Note the formula also works for a monopoly, when s=1
 The quantity
𝑝−𝑀𝐶
𝑝
market power
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is called the Lerner index. It is a measure of
Measuring market concentration
 The most commonly used measure of market concentration is
the Herfindahl-Hirschman index (HHI)
– It is equal to the sum of the market shares squared
– For instance, with three firms with 50, 40 and 10% market shares,
HHI=502+402+102=4200
 In the Cournot model, the Lerner index is equal to HHI/ε
– There is a neat relationship between market power and market
concentration
 Competition authorities frequently use the HHI, in particular to
assess mergers
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Market power
 The preceding slides suggest there is a clear relationship
between market power, number of firms, market shares and
HHI
– Notice however that all these results are based on the Cournot
model and so do not always generalize to other models
– In a Bertrand model, we know two firms are sufficient to lead to
the perfect competition equilibrium
 In practice, one has to run a complete analysis of competition
on the market
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Market power
 For instance, a single firm can be unable to use its market power
– On some markets, entry is costless
– If the incumbent increases prices (and its profits), then these will
immediately attract new entrants and force the incumbent to reduce
prices
– Faced with this threat, the incumbent cannot raise prices and the
competitive equilibrium is reached
 These markets are called contestable
– Low-cost airlines are an example
 Market shares may be a poor indicator of market power
– It also underlines the importance of barriers to entry to understand
market power
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Market concentration determinants
 Monopoly/Oligopoly profits should attract firms
– However, incumbents always have more of an incentive to block
entry that the entrant has to enter
 Many markets support only a fixed number of firms
– For instance in equilibrium, profits may be negative with three
firms such that only two can survive
– This often occurs when sunk costs are important
– Or when large firms are much more efficient than small ones
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Market concentration determinants
 Barriers to entry help preserving market power
– Capital requirements to cover fixed costs
– R&D
– Regulatory requirements
– Patents offer market power on a product for a limited time period
 Incumbent firms can adopt strategies to maintain market power
– Product proliferation
– Patent thickets
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Product proliferation
 Firms use horizontal differentiation to reduce competition
intensity
– They move away from other brands’ products
 However, another strategy is to occupy the whole product
space to not let entrants differentiate horizontally
– In 1921, General Motors decided to offer a complete spectrum of
automobiles
– In 1961, Swedish Tobacco was about to lose its monopoly and
decided to launch twice as many brands and to increase its
advertising twelvefold
– The six leading manufacturers of ready-to-eat breakfast cereals
introduced 80 brands between 1950 and 1972
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Patents
 Patents prevent new entries
– There is an efficiency argument to patents: they promote
innovation
– There is also an inefficiency argument
 The strategy consists in patenting every single innovation to
block future entries
 It also consists in buying many patents to avoid future entry
– Google has been under constant attack by Microsoft and Apple
– In 2012, it bought Motorola Mobility… and its 17 000 patents!
– Google said it planned to use the patents to ward off lawsuits from
Apple and Microsoft
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