Industrial Organization
Exam Two
Friday May 15
Spring 2009

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I. Computers

    A. Mainframes
        1. product differentiation
            a. incompatible systems
            b. software lock in
        2. technological change
        3. economies of scale
            a. research and development
            b. high set up costs
        4. network externalities
            a. usefulness increases with total number of users
            b. advantage to industry leader
        5. Dominant firm
    B. IBM
        1. fast second strategy
        2. pre-announcement of products
        3. tying
        4. price discrimination
        5. aggressive response to entry
    C. Antitrust case (IBM)
        1. Sherman Act Section two (monopolization)
        2. filed 1969
        3. dropped 1982
        4. unresolved issues
            a. when is pricing predatory
            b. how much power can a dominant firm use against rivals
    D. Microcomputers
        1. IBM late entrant in market
        2. chooses open architecture
            a. network externalities
            b. microchip from Intel
            c. operating system from Microsoft
        3. IBM market share peaks at 80%
        4. entry
            a. rivals buy Intel chip, Microsoft software
            b. compatible computer
            c. IBM's market share erodes rapidly
        5. hardware manufacturing becomes very competitive
            a. low cost producers displace IBM
            b. low margin, commodity business
    E. Microsoft
        1. software characteristics favor one dominant firm
            a. large economies of scale
i. high set up costs
                ii. low marginal costs
            b. network externalities
        2. conduct
            a. exclusionary licensing
            b. technical incompatibilities
            c. tying
i. Word, Excel, Powerpoint
                ii. Internet Explorer
            d. pre-announcement of programs
    F. Antitrust  (Microsoft)
        1. consent decree (1994)
        2. monopolization case (1998)
        3. Microsoft found guilty of violating Sherman Act
            a. court orders break up
            b. appeal
            c. break-up reversed
            d. settlement (2001)
            e. States argue for stricter remedy (most cases settled 2003)
       4. European antitrust case
             a. similar grounds
             b. Microsoft guilty: large fine
       5. Private cases
             a. guilty finding hurts Microsoft's defense

b. treble damages
             c. pays large dollar amounts to settle claims by several firms

II. Semiconductors

    A. Characteristics
        1. integrated circuits on microchip
        2. rapid technological advance
        3. Economies of scale
            a. research and development
            b. set up costs
    B. Learning curves
        1. production process improves with experience
            a. costs inversely related to total production (over time)
            b. marginal cost may be substantially less than material costs
        2. cost advantage to industry leader
            a. strategic pricing
            b. dominant firm
        3. limits to learning curve advantage
            a. eventual flattening of learning curve
            b. buyers desire second source
            c. spillover
            d. production constraints during early stages
C. Dominant firms

III. Monopolization

A. Sherman Action, Section Two
1. American Tobacco
a. dominant firm created by mergers
b. antitrust case (1911)
c. break-up
2. US Steel
a. dominant firm created by mergers
b. antitrust case
c. not guilty
i) price umbrella allowed rivals to thrive
ii) US Steel lost market share

B. Rule of Reason
1. Dominant market share alone is not illegal
a. economies of scale
b. superior management
c. efficiency
2. Conduct matters
3. Each case judged on its specifics

IV. Airlines

    A. Industry Conditions
       1. moderate concentration nationally
       2. very high concentration in some airports and routes
       3. cyclical demand
          a. recession
          b. terrorist attacks
         c. Federal bail-outs
4. fuel costs
5. bankruptcy of major carriers  (reorganization)

     B. Vertical elements
       1. Aircraft
          a. duopoly
i. Boeing
             ii. Airbus
          b. used market
          c. large economies of scale
       2. Airports and Air Traffic Control
          a. public provision: FAA, State and Local govt
          b. taxes
       3. Very limited vertical integration
          a. reservations systems
          b. baggage handling

    C. Economic Regulation
        1. Civil Aeronautics Board (1938)
            a. response to industry complaints about "destructive" competition
            b. not a Natural Monopoly
            c. CAB determines rates and service
i. high prices
                ii. high profits
                iii. minimal competition
                iv. little entry
        2. non-price competition
            a. each additional passenger was very profitable
            b. attract passengers through service and quality
i. meals
                ii. stewardesses
                iii. frequent flights
            c. excess capacity
            d. elevated costs

    D. Deregulation
        1. Airline Deregulation Act (1978)
            a. eliminate price regulation
            b. allow free entry
            c. eliminate CAB
        2. Entry
            a. 60 new carriers (by 1983)
            b. expansion of regional carriers       
        3.  Prices fall
        4. Hub and spoke network
             a. efficiency gains
             b. less convenient for travelers
       5. Quality falls

       6. Price discrimination
            a. "yield management" systems
            b. no arbitrage
            c. very profitable
        7. Frequent Flier programs
            a. non-price competition
            b. principal agent issue  

    E. Oligopolistic behavior
          1. concentration increased
             a. mergers
             b. failures
          2. Price leadership (AA)
          3. Price coordination through reservation systems

    F. Contestable markets
        1. assumes no barriers to entry
        2. fear of entry would keep monopolist's prices low
        3. influential theory but not applicable broadly
        4. Are airlines contestable?
a. capital mobility (planes)
            b. barriers to entry
i. slots
                ii. gates
                iii. retaliation by incumbents

V. Price Fixing

A. Sherman Action, Section One
1. GE- Westinghouse
a. patent intentionally creates monopoly
b. patents are one of the very few defenses
c. firms later convicted of price fixing in other lines of business
2. Ivy League Overlap Group
a. financial aid coordination
b. antitrust investigation
c. practice is illegal

B. Per Se illegal
1. Price fixing by competitors is broadly prohibited
2. Courts do not need to consider reasonableness or efficiency arguments
3. Very clear standard

VI. Mergers

A. Cases
1. Brown Shoe
2. Coca-Cola Dr Pepper

B. Laws
1. Sherman Act Section Two (1911)
a. prevents mergers to create a monopoly
b. only prohibits extreme instances
2. Clayton Action, Section Seven (1914)
a. prevents mergers that substantially lessen competition
b. level of enforcement varies
i. at times, relatively small horizontal mergers have been prohibited
ii. Other times larger mergers have been allowed
3. Cellar Kefauver Amendment (1950)
4. Hart Scott Rodino Act (1976)
a. requires prior notification for large mergers
b. FTC and Department of Justice review
c challenged mergers usually dropped by firms before court case

C. Merger Guidelines
1. signal to firms by FTC & Dept of Justice
2. large horizontal mergers in concentrated markets are most likely to be challenged
a. if Herfindahl Index < 1000, mergers safe
b. if 1000<Herfindahl <1800
i) small mergers safe (change in H<100)
ii) large mergers challenged (change in H>100)
c. if Herfindahl >1800
i) most mergers by big firms challenged
ii) very small mergers safe (change in H<50)

D. Rule of Reason
1. market power vs efficiency
a. substantially lessen competition (price increases)
b. economies of scale, management (cost decreases)
2. most mergers are small, and legal
3. even large horizontal mergers are considered on the specifics of the case

E. Other types of mergers
1. Vertical mergers
2. Conglomerate mergers
3. International mergers

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Industrial Organization and Public Policy

Chuck Stull

Department of Economics

Kalamazoo College