Chapter 1 Flashcards
In order to determine a firm’s dominance in the market…
We need to determine the extent of its individual market power
Can we tell from market outcomes whether firms are imposing genuine competitive constraints on one another?
idk!
The structure-conduct-performance approach (Pros and cons)
-Regarded as old fashioned (vs game theory)
-Presumes a CAUSAL link between the structure of the market, the nature of the competition and market outcomes (p,q, profits)
in the SCP approach, the indicators for market power are useful…
For structural thresholds, but they are not used as conclusive evidence of market power.
Structural proxies for market power are usually justified by?
- The Cournot model.
- Good information on MC is rare, if we assume competition we can infer probability
Derive the Lerner Index from a Cournot model
Takeaways from the Cournot theory (and Lerner index)
- Determine the markup of the firm using the market share and elasticity.
- If the firm has a higher share (s_i), then it can increase the markup.
- If the price sensitivity is high, then the markup is likely lower.
Thus, a high share of the market is not sufficient to ensure high markups, we need to evaluate price sensitivity as well.
What are the most used structural indicators of profitability?
The Herfindahl-Hirschman Index and the Concentration ratios
The HHI, formula
Why is the HHI used?
As a preliminary benchmark in merger controls when post-merger data is not observed.
How do we compare HHI pre and post merger?
For post s_i, we assume that it will be the sum of the s_i of the merging firms.
What are the main disadvantages of HHI?
needs data on volume or value of sale for ALL companies in the market.
Concentration index formula
Criticisms of the Structure Conduct Performance approach
- In real life, causality is not unidirectional (econometrics).
- For Bain 1951, using accounting data is not good enough to measure MC.
- Comparisons across industry are problematic
- profits, L, and s_i should be positively correlated, but we can’t affirm a causal link from concentration to profitability:
– A more efficient firm will have lower costs and higher concentration.
– If we introduce a policy to reduce concentration, production will move from efficient to inefficient firms in this case, therefore the CS might not change or be worsened.
-Other criticism: difficulty in obtaining firm’s profits.
Alternative to SCP
Instead, use Game theory approach: market structures, conduct and performance emerge together as jointly determined outcomes of a model.
Conclusion on the SCP cons from observable data:
The positive correlation between profits and market structure is robust across industries, but it probably has complex causes that may differ across industries.
Since assessing profits can be difficult, what can we use instead for Lerner?
(AR-AVC)/AR, but only if AVC is similar to MC
This ignores fixed costs of entry, which reduces the analysis to short term comparative statistics.
Data from financial documents (accounting) is used in other assessments, but typically not in IO.
Directly identifying the nature of competition with GT. Why?
Small differences in institutional or tech characteristics can lead to very different equilibrium outcomes.
Directly identifying the nature of competition with GT. How?
Use observed data on cost drivers, p and q in order to infer the nature of competition.
When we have two models that may have generated the same data, we use “identification strategies” to tell them apart (features of the data).
What does the theoretical analysis of the formal structure models of supply and demand show?
When a variable affects both S and D, we will only be able to separately identify the magnitude of the effect on p and q outcomes in particular circumstances. We can generally observe reduced-form effects but we will only be able to trace back the actual parameters of the demand and supply functions in particular circumstances.
We can learn about the parameters using changes in exogenous cost and demand shifters.
Conditions for Identification of Pricing Equations
Traditionally, there must be a shifter of demand that does not affect supply and a shifter of supply that does not affect demand.
By including variables in the regression that are present in one of the structural equations but not in the other, we allow one of the structural functions to shift while holding the other one fixed.
Conduct Parameters (Bresnahan (1982)). What does he show?
He shows the conditions under which we can use data to tell apart three classic economic models of firm conduct, namely Bertrand price competition, Cournot quantity competition, and collusion
Conduct Parameters (Bresnahan (1982)). What is the firm’s strategy for all three cases?
Firms that maximize static profits do so by equating marginal revenue to marginal costs.
However, under each of the three different models, the firms’ marginal revenue functions are different. As a result, firms are predicted to respond to a change in market conditions that affect prices in a manner that is specific to each model.
Conduct Parameters (Bresnahan (1982)). Example: perfect competition with zero fixed costs.
A firm’s pricing equation is simply its marginal cost curve and hence movements or rotations of demand will not affect the shape of the supply (pricing) curve since it is entirely determined by costs. In contrast, under oligopolistic or collusive conduct, the markup over costs—and hence the pricing equation—will depend on the character of the demand curve.
Conduct Parameters (Bresnahan (1982)). The marginal revenue by market structure model. Nested equation and parameter meaning.
This parameter was named the “conjectural variations parameter” as it reflects firm j’s conjecture on how Q changes when qj changes (BUT name debated because identification challenges)
Conduct Parameters (Bresnahan (1982)). The firms’ total revenue TR in each case
If we take the derivative, we find the MR, which we can then nest into the Bresnahan equation
Conduct Parameters (Bresnahan (1982)). Equilibrium
MR=MC
The pricing equation encompassing these three models will depend on both the quantity and the cost variables. Its parameters are determined by the parameters of the demand function, the parameters of the cost function, and the conduct parameter, lambda.
Which conditions allow us to identify lambda when cost information is available?
- If the MC are constant in q, then if we can estimate the demand parameter and the gamma, we can identify lambda.
-Alternatively, if we are confident of our cost data, then we could estimate a cost function, or a marginal cost function and then we could equally potentially estimate ˇ1 directly.
Which conditions allow us to identify lambda when cost information is NOT available? Demand Shifts
Without information about costs, the only market events that one could use for identification are changes in demand.
When do demand shifts arise? And demand rotations? Do they suffice to identify conduct parameters?
Demand shifts arise, for instance, because of an increase in disposable income available to consumers for consumption. Demand shifters are not generally useful for identifying the nature of conduct in the market.
Demand rotations on the other hand must be factors which affect the price sensitivity of consumers. Demand rotators will usually suffice to estimate lambda.
Draw the changes in price and quantity in a market following a shift in demand from D1 to D2.
The aim of the figure is to demonstrate that the demand shift provides no power to tell the two potential underlying models apart (unless we have additional information on the level of costs) even though demand shifts do successfully trace out the pricing equation for us.
Identifying Conduct when Cost Information Is Not Available: Demand Rotations
Because each competition strategy sets MR=MC but has different MR, the determinants of the pricing curve are different.
Each model places a differential importance on the slope of (inverse) demand for the pricing equation.
Draw the changes in price and quantity in a market following a rotation in demand from D2 to D3 for a price taking firm (C) vs a monopolist (M)
If a variable affects the slope of demand, then each of the three models will make very different predictions for what should happen to prices at any given marginal cost.
In the competitive case absolutely nothing should happen to markups while a monopolist will take advantage of any decrease in demand elasticity to increase prices.
Effects of a demand rotation on the marginal curve of oligopolistic firms
Flatter demand and marginal revenue curves will cause firms with market power to lower their prices. On the other hand, price-taking firms will keep the price unchanged since lowering the price would cause them to price below marginal cost and make losses
Summary of effects of demand rotations on each competition strategy
Intuitively, demand rotations allow us to identify conduct even when we have no information about costs because such changes should not cause any response in a perfectly competitive environment, there should be some response in a Cournot market and a much larger response in a fully collusive environment.
If demand becomes more elastic, prices will decrease and quantity will increase in a market with a high degree of market power. If, on the other hand, demand becomes more inelastic and consumers are less willing to adjust their quantities consumed in response to changes in prices, then prices will increase in oligopolistic or cartelized markets. Prices will remain unchanged in both scenarios if the market is perfectly competitive and firms are pricing close to their marginal costs.
SCP paradigm direction of effects
Typical SCP regression
What does Bain 1951 find?
Uses data on cross-section of industries and accounting data to measure MC.
He finds that the parameter related to concentration is positive, so from the SCP paradigm standpoint, concentration increases prices.
This has a Cournot motivation, market power is proportional to market shares and elasticity
Why is accounting data problematic?
- Physical capital is typically valued incorrectly (not opportunity costs)
- Investments that provide future profits may be treated as expenditure at the current time even though the impact is long term
- Difficult to find accurate depreciation rates.
- Firms are not typically mono-product
Application related to Market Structure Endogeneity
From Mad Men to Maths Men: Concentration and Buyer Power in Online Advertising, Decarolis & Rovigatti, AER, 2021
Hypothesis?
Mergers lead to higher bargaining power of intermediaries
BUT not clear what is the effect of the resulting concentration Potential “avoid sleeping with the enemy” mechanism. Advertisers might be avoiding mergers with direct rivals
Estimating the demand and supply equations: Perfect competition
Estimating the demand and supply equations: Cournot
Same endogeneity problem as Bertrand, use IV!
Estimating conduct (Intuition from Bresnahan). Cournot with identical firms. Obraining the Lerner index depending on the conduct estimation parameter
Estimating the conduct parameter when marginal costs are known
1) Substitute in the marginal cost function the parameter relating to Q_t to beta1-phi\alpha_1
2) Obtain \alpha_1 from the demand estimation
3) if MC are constant, then b1=0-> the only unknown in the new parameter is phi
Note: this equation comes from MR=MC, where MR depends on phi-> solve for P
Estimating conduct when cost information not available: demand rotators
The last equation being the new pricing equation
Summing up and clarifications for chapter 2
Cartel theory from Green-Porter
What is slutsky symmetry
Demand equation in multi-stage budgeting (AIDS)
Possible price indices for AIDS
We need indices that are invariant to the choice of units of measurement (homogeneity of degree 0)
Elasticities in AIDS model
Multinomial Logit general approach
Logit approach: 1.-Individual utility
Logit approach 5. Inverting the market share system
Equating the market share logit function to the observed market share (qj/L) gives us a system of equations… although highly nonlinear!
Berry shows that from this system we can recover mean utility
For 4, it would be good to mention that we need BLP instruments to be independent of a product’s specific demand shocks. This is the case if you assume that competitors can’t/don’t adjust their observed product characteristics in response to unobserved product characteristics/demand shocks of the specific product.
● Each market is a country/year combination. Therefore, your instruments should be calculated at a country/year level, instead of just a year level. Notice the same car will show up multiple times if you do it across all countries in the same year, so the instruments don’t make sense. I’m guessing this is what caused your weird results later for IV versions of the model and the questions using the IV estimated coefficients
Nested logit with aggregate level data
Berry 1994 model
