Holdup Problem and Introduction to Market Structures

Question 1

Trade-off - Vertical Integration

Answer 1

Using market improves technical efficiency (least cost production)
• ! Vertical integration improves agency efficiency (coordination, transactions costs)
• ! Firms should “economise”:
! That is, choose the best possible combination of technical and agency efficiencies

Question 2

Why Transaction Costs?

Answer 2

• If market mechanism improves efficiency, why do so many of the activities take place outside the price system? (Coase)
• Costs of using the market are saved by centralised direction - transactions costs
• Outsourcing entails costs of negotiating, writing and enforcing contracts etc.
○ Note:
• Transactions costs can occur inside (intrafirm) as well as outside/between (interfirm) [See: Williamson and after]

Question 3

Other Sources of Transaction Costs

Answer 3

Investments that need to be made in relationship-specific assets
• Quasi-rents?
• Opportunistic behaviour after the investment is made (holdup problem)

Question 4

Relation-Specific Assets

Answer 4

• Assets essential for a given transaction
  
  • Can’t be redeployed for another transaction without incurring cost
  • Once asset is in place, other party to the contract cannot be replaced without cost

○ Why?
§ Contracting parties locked into relationship to some degree (depends on renegotiation clause(s)) etc.

Question 5

Different forms of relation-specific assets

Answer 5

• Site specificity (geography, clustering)
  
  • Physical asset specificity (tech)
  • Dedicated assets (specific buyer)
  • Human asset specificity (knowledge, skills…learning)
  • Others?

Question 6

The Problem with Holdup

Answer 6

Holdup increases cost of transacting exchanges:
• Contract negotiations more difficult
• Investments may have to be made to improve ex-post bargaining position
• Potential holdup can cause distrust
• May be underinvestment in relationship- specific assets

Question 7

Hold-Up Problem and Transaction Costs

Answer 7

Holdup potential may lead to investment in wasteful protective measures
• Manufacturer may acquire standby production facility for an input that is to be obtained from a market firm
• Floating power plants are used in place of traditional power plants to avoid site specific investments

Question 8

Patent holdup

Answer 8

arise when circumstances enable a patent owner to extract a larger royalty ex post than it could have obtained in an arms length transaction ex ante.

Question 9

Markets and Strategy

Answer 9

• If one firm’s strategic choice adversely affects performance another = competitors
  
  • Firms may have competitors in several input and output markets at same time
  • Competition can be either direct or indirect

Question 10

How to Identify Competitors:

Answer 10

Intuitive:
○ ! Product performance characteristics
○ Occasions for use
○ ! Geography

• Data-driven:
○ ! Various metrics e.g. Cross-Price Elasticity of Demand

Question 11

Market Structure

Answer 11

Markets described by degree of concentration
! Main approaches:
○ ! N-firm concentration ratio:

	○ Herfindahl index:

Question 12

N-firm concentration ratio:

Answer 12

Combined market share of largest N firms

Question 13

○ Herfindahl index:

Answer 13

sum of squared market shares

now HHI with range 0-10000

Question 14

Hirschman-Herfindahl Index (HHI)

Answer 14

○ used when assessing concentration levels to enforce U.S. antitrust laws.

○ HHI scores of less than 1,000 are thought to indicate an unconcentrated market with no competitor able to exert market power.

Sum of market share ^2 of own firm in the market

Question 15

Perfect Competition

Answer 15

Price competition can be ‘fierce’ when two or more of the following conditions are met:
• Many sellers - costs below sector ave., collusion, cheating
• Customers perceive product homogenous - when lower price=buy more; new customers; switching from competitors

conditions:

• many sellers
• homogeneous products
• excess capacity

Question 16

Monopoly

Answer 16

• Supernormal profit at MR=MC (P>MC)
  
  • Genesis of monopolists (Demsetz) • Efficiency? (relative to competitors
  • Create new products (meet unmet needs)
  • Innovation - funded by profits, leads to (potential) benefit for consumers

Question 17

Monopolistic Competition

Answer 17

Supernormal profit at MR=MC (where, P>AC) in SR
• Pricing at P=AC=AR (and at output MR=MC) in LR
• Many firms - not interdependent
• Products differentiated (heterogeneous):
○ Understand and develop this - v.imp in value creation and in Porter’s ‘Generic Strategies’
○ Combined with cost advantage -> Profit and market entry
Brands and loyalty - Strategic flexibility

Question 18

Differentiation:

Answer 18

Vertical - distinct levels of quality
• Horizontal - differences across segments:
• Idiosyncratic differentiation - location and tastes which limit switching behaviour (to competitor)

Question 19

Search Costs

Answer 19

cost of finding out about products:

• Low cost products=low differentiation=low search costs=low profit

Question 20

Oligopoly

Key features:

Answer 20

Strategic interaction
• Number of firms (that strategically interact)
• Pricing & Output decisions affect market outcomes

Question 21

Oligopoly

Models:

Answer 21

• Cournot (Quantity - Simultaneous)
  * Bertrand (Price - Simultaneous)
  * Stackelberg (Quantity - Sequential)
  * Other e.g. Price Leadership (Price - Sequential)

Question 22

Oligopoly

Reaction Functions:

Answer 22

Optimising (Profit Max. level, given other firm)

• Market-Clearing
• Other assumptions: Costs; Homogeneity of product.

Question 23

Cournot Oligopoly

Answer 23

Special Case: Duopoly (homogenous)
• ! If two firms identical to begin with, outputs equal
• ! Each firm expects rival chooses Cournot equilibrium output
• ! If one firm is off equilibrium, both firms have to adjust their outputs
• ! Equilibrium = point where further adjustments not needed:
! Cournot equilibrium = Nash Equilibrium
• ! But, ‘revenue destruction’ (See: pp.174-5)

Question 24

What about Bertrand Oligopoly?

Answer 24

Firms select the price and sell whatever quantity is demanded
• ! Each firm takes the price set by its rival as a given, and sets its own price to maximise its profits (reaction function)

! In equilibrium, each firm correctly predicts its rivals price decision

Question 25

Bertrand Oligopoly

! Special Case: Duopoly (homogenous)

Answer 25

If firms are identical they will set the
same price as each other
! P=MC (same as perfect competition)

! Why?  Otherwise each firm will have incentive to undercut the other

Question 26

Bertrand Oligopoly

!Now: heterogeneous

Answer 26

When products of rival firms are differentiated, demand curves are different for each firm:
○ ! They are reaction functions
○ ! Equilibrium prices are different for each firm and > MC
○ ! Price cutting not as effective for stealing business

Question 27

Oligopoly Models - Comparisons

Answer 27

Output adjusted quickly -> Bertrand
• ! Output cannot be increased quickly (capacity decision is made ahead of actual production) -> Cournot
• ! In Bertrand, min. of two firms sufficient to produce same outcome as infinite firms (Paradox!)

Question 28

Market Structures - Causes?

Answer 28

Greater market concentration if:
○ ! larger the minimum efficient scale (MES) of production
○ ! If entry (exit) not easy

• !Monopolistic competition means easier entry and larger number of firms

Question 29

Markets and Sunk Costs

Answer 29

Consumer goods markets seem to have a few large firms and many small firms
• ! Advertising costs or production costs (Sutton 2006)
! Advertising costs as endogenous sunk costs
• ! Early in the industry’s life cycle many small
firms compete
• ! Winners invest in brand name capital and grow
• ! Smaller firms can try to match investment and build their own brands or differentiate their products and seek niches

Question 30

Markets and Price-Cost Margins

Answer 30

Theory predicts price-cost margins higher in industries with greater concentration 
! But, variation in price-cost margins? 
	• Regulation
	• Accounting practices
	• Concentration of buyers (monopsony)

Question 31

Markets and Concentration

Answer 31

It is important to control for these extraneous factors to study the relation between concentration and price-cost margin
• ! Most studies focus on specific industries and compare geographically distinct markets
• ! For several industries, prices are found to be higher in markets with higher concentration
Empirical research continues, linking boundaries of firm and market structures:
! Scale and Scope and Structure
! Vertical boundaries and entry barriers
Vertical integration and innovation