Industrial organization perspective 1 Flashcards
Explain the Structure-Conduct-Performance Approach
Hypothesizes a direct cause effect from basic market conditions (supply and demand) relationship between market structure, market conduct and market performance (and Government policies).
(Market structure predicts conduct which predicts performance)
Explain the Chicago School Approach
Relies heavily on price theory models to make predictions about expected conduct and performance
Explain the New Industrial Organization approach
Uses game theory to model the behavior of firms within duopoly and oligopoly markets
What are the three major industrial organization approaches?
Structure-Conduct-Performance
Chicago School Approach
New Industrial Organization
Bargaining position of consumers and producers is limited by three rivalries in market transactions
Consumer – Producer
Consumer – Consumer
Producer – Producer
Porter’s Five Forces
Entry Power of Buyers Substitutes & Complements Industry Rivalry Power of Input Suppliers
Explain Accounting profit, Economic profit, and profitability
- Accounting Profit is the total amount of money taken in from sales (total revenue) minus the dollar cost of producing goods or services
- Economic Profit is the difference between total revenue and the total opportunity cost of producing goods or services
- Profitability is profit in relation to a scarce resource (NPV)
Transaction costs could be divided into two main categories
- Co-ordination costs
Inside (firm transaction/management cost)
Outside (market transaction cost) - Motivation/Information cost
Due to opportunistic behavior and imperfect contracts (Adverse selection and moral hazards)
Transaction costs have three dimensions
Frequency
Uncertainty
Asset specificity
Williamson’s managerial utility model
Management seeks to maximize own utility rather than the owners.
Managerial objectives
Maximize own utility
Maximize sales revenue
Satisfying rather than maximizing profit
Asymmetric information problems
- Pre-contractual opportunism and adverse selection
- Post-contractual opportunism and moral hazard
The Lemon problem
Sellers and buyers have different information about the quality
Sellers now the quality of each car, whereas buyers only now that there are better and worse cars
Buyers therefore assumes that a car is of average quality (pay market price for average quality
Sellers don’t want to sell high quality cars to the price of an average car
(Unless sellers can credible disclosure the quality of cars)
How does Adverse selection impact firms’ capital structure decisions?
- Signaling theory
- Pecking-order theory
What can lead to agency costs between the principal and the agent?
Different:
- Objectives
- Preferences
- Business strategies
- Dividend policy
- Growth strategies
- Attitudes to risk
How can moral hazard be recognized according to principal agent theory?
Management acting opportunistic by:
- Insufficient effort
- Extravagant investments
- Entrenchment strategies (strategies that only benefit managers and not shareholders)
- Self-dealing
(Agency costs = Value if managed by the interest of shareholders – current value)
Monopolistic competition
Large number of buyers and sellers
Easy to entry
Differentiated product
(has limited predictive capability.
Oligopoly
Relatively small number of firms control the market
The Neoclassical firm
Regardless of industry structure, each firm is assumed to maximize profits. Making it possible to precisely predict output and pricing decisions.
The Theory of the firm
Recognizes that the firm is not an individual decision maker, but rather a series of contract between parties.
This creates problems such as transaction costs, bounded rationality, and opportunistic behavior
Bounded rationality
Assumes limits in knowledge, foresight, time, and skill constrains an individual’s ability to solve complex problems. Thus, a firm cannot write a contract ahead of time that covers everything. However, even incomplete contracts could be used to carry out transactions, if it were not for the presence of opportunism.
Transaction costs increase as it becomes more difficult to write contract that limits opportunistic behavior. What are the three circumstances that are important to identify?
- Frequency
- Uncertainty
- Asset specificity
(when transaction costs are high, firms are likely to rely on internal production rather than the market)
Give one example where accounting cost and economic cost are the same and one where they differ
- Wages are often valued the same
- Machines often differ
Explain returns to scale and diseconomies of scale
Returns to scale could be:
- Constant, proportionate increase in inputs leads to the same increase in output
- Increasing, proportionate increase in inputs leads to a higher increase of output
- Decreasing. decreasing means that an amount of input will results in a smaller amount of output
If the firm doubles the output with the cost more than doubling, they suffer from diseconomies of scale.
(This decides the shape of long run average cost)
Explain economies of scope
It derives from several outputs sharing the same inputs, such as research knowledge or fixed factor such as a machine
What are the assumptions of perfect competition?
- Large number of buyers and sellers
- Homogeneous product
- Perfect information
- No transaction cost
- Free entry and exit
(Firms and consumers are price takers)
Describe perfect competition in the short and long run
- Short run, a firm will produce the output for which price equals marginal cost as long as that price is greater than or equal to variable cost (P=AVC, shutdown point).
(Think about sunk cost as well) - Long run, a firm will continue to produce as long as total revenue is greater than or equal to long-run average cost.
Describe a monopoly firm
A monopoly is the sole producer of a good for which there are no close substitutes. A monopolist, like any other profit maximizing firm, will produce until MR = MC. Unlike a perfect competitive firm, revenue for a monopolist does not equal price.
Lerner index
Indicates that even a monopolist has only limited control over price. If price elasticity of demand is high, the profit maximizing price will be relatively close to its marginal cost. A less elastic demand will thus result in a larger monopoly markup.
Deadweight loss
Measures the misallocation of resources due to monopoly. This problem arises because the monopoly price is greater than the marginal cost of the good. This is the fundamental problem associated with monopoly power.
DWL = Customer surplus in perfect competition - monopoly profits - customer surplus in monopoly
Describe the difference between the short run and the long run
- Short run, the firm could not adjust all inputs and no entry into or exit from the industry could occur.
- Long run equilibrium, entry or exit had occurred, resulting in zero economic profits, and the firm had adjusted the level of all inputs optimally
Explain Concentration ratio and Herfindahl-Hirschman Index
.
What are the four Strategic or Structural barriers to enter according to Bain?
- Economies of scale
- Absolute cost advantages
- Capital cost advantages
- Product differentiation advantages
Structural barriers - factors firms have no control over
Strategic barriers - factors dependent on firms behaviour
Advertising can create an advantage for incumbents through three factors
- Absolute cost advantage
- Economies of scale
- High capital cost of entry
Conglomerate mergers can be divided into three types
- Product extension merger
- Geographic extension merger
- Pure conglomerate merger
What can be said about structure of modern firms?
Separation of ownership and control
Managerial objectives
Behavioural approaches to the governance of modern firms
Stress the importance of internal structures:
- Multi objectives rather than one single goal
- Hierarchy of goals
- Conflicting interests
- Firm survival
The governance of modern firms
Limited to unlimited liability
Separation of ownership and control
Managerial objectives
Behavioural approaches
Paint the four-fielder of incentives for vertical integration in downstream/upstream monopoly and competitive firms
(DS Monopoly, US Monopoly) = Strong incentives for integration
(DS Monopoly, US Competition) = Strong incentives for competitive firm to integrate downstream
(DS Competitive, US Monopoly) = Strong incentives for competitive firm to integrate upstream
(DS Competition, US Competition) = Weak incentives for integration
Hold-up problem
When two parties would be better of when completely cooperating but refrain from doing so because of incomplete contracts where one party don’t want to give the other bargain power
