Industrial
Organization
Final Exam
Monday June 8, 8:00 am
Spring 2009
The final exam will be comprehensive. You should
review the material we covered for Exam One and
Exam Two . You
will probably want a calculator for this exam.
A. Health care industry (and cost) is large and growing
B. Industry structure
1. concentration data appears to be relatively modest
2. non-competing products
a. different medicines treat different diseases
b. level of competition varies
i. some markets are quite competitive
ii. some markets are monopolies
iii. others are oligopolistic
3. new drug innovation
C. Regulation
1. FDA
2. approval process
a. costly
b. lengthy
3. without exclusivity, rivals could copy an approved drug and avoid high costs
D. Product differentiation exists between competing products
1. first mover advantage
a. with or without patent
b. higher price and higher volume
2. value of brand image enhanced by promotional spending
3. competing products are valued lower by consumers, even if chemically identical
4. quality comparisons are difficult
E. Consumers
may be insensitive to price
1. principal
agent problem
a.
physician/patient
b.
patient/insurer
2. can
contribute to rising health care costs
3. policy to encourage generic
equivalents
F. Patents
1. 20 year monopoly
2. trade-off
deadweight loss for benefits of innovation
3. breadth of
patent questions and "me too" drugs
4. patent races
i.
winner gets monopoly profits
ii. second
place firm loses costs sunk into R&D
iii. possible incentive to over-invest in research
G. International aspects
1. many
pharmaceuticals are protected by patents
2. WTO agreement covers intellectual
property
a. TRIPS
(Trade related aspects of intellectual property rights)
b. WTO
members must (by 2006):
i. provide patent protection
ii. limited exceptions are allowed
- "national emergency"
- compulsory licensing
c. countries
without patent protection have transition period to protect
3. Patents and poor countries
a. monopoly
rights put price out of reach of poorest consumers
b.
trade-off: property protection or access to treatment
II Antitrust and business practices
A. Price discrimination
1. Necessary conditions
a. monopoly power
b. separate
segments by willingness to pay
c. prevent resale
2. Welfare
effects
a. less consumer
surplus
b. more profit
c. less deadweight
loss
3. Laws
a. Clayton Act,
Section two
b. Robinson Patman Act
4. Cases
a.
b. Anhueser Busch
B. Resale Price Maintenance
1. Vertical price fixing
a. manufacturer
sets retail price
b. Sherman Act,
Section One
c. reduces
competition between retailers
2. Cases
a. Dr Miles (1911)
- per
se violation
b. Leegin (2007)
i) makes efficiency argument: fixed prices=better service
ii) Supreme
Court changes to rule of reason standard
C. Predation
1. Strategic behavior aimed at causing
rivals to exit
2. Predatory pricing
a. pricing below cost
b. widespread
accusations in the airline industry
3. competing
theories
a. predation is
irrational
b. predation may be
rational, but it's too costly
c. reputation effect
i. predatory pricing as an investment
ii.
accept losses now
iii. discourage future competition
iv.
"irrational" behavior can maximize long-run
profits
D Tying
1. Tie-in
sales or bundling
2. requirement
to buy multiple products together
3. extend
market power from one product to tied product
4. restricted
by Clayton Act, Section Three
5. Cases
a. International
Salt
b. Kodak
c. Microsoft
E. Unfair Business Practices
1.
2. Clayton
Act
3. Federal Trade
Commission
A. Natural monopoly
1. cheaper
for one firm to serve market than for 2 or more firms
2. large
set up costs
3. network
externalities
4. maintaining
a large number of competing wire networks is not efficient
5. natural
monopoly not suited to break-up
a. public
ownership
b.
regulation
B. Regulation
1. government
approves telephone rates (prices), services, returns, investments
2. Federal and
State agencies
a. FCC
b. Public
Service Commissions or Public Utility Commissions
3. other
regulated industries included:
a.electricity
b. natural
gas
c. railroads
d. trucking
e. airlines
C. Price regulation
1. optimal
price may be below ATC
a. fixed
costs are often high in natural monopolies
b. P <
ATC: short run loss/ long run exit
2. Ramsey pricing
a. price
closest to marginal cost that allows firm to break even
b. average
cost pricing
3. asymmetric
information problems
a. firm may
not accurately reveal costs
b. incentive
to over-build
D. Capture
1. firms
may use regulatory agencies as an anticompetive
device
a. tax
others, subsidize firm
b. restrict
entry
c. regulate
substitutes to restrict competition
d. price
regulation eliminates price competition
2. movement
to deregulate
-- alternatives
a. auction
of monopoly franchise
b. contestable
markets
c. intermodal competition
E. AT&T
1. vertically integrated regulated
monopolist
a. Bell Labs
(research)
b. Western
Electric (manufacturing)
c. Long
lines department (long distance telephone service)
d. local
operating companies (local phone service)
2. only
local service was true natural monopoly
a. firms
tried to enter other sectors
b. AT&T
responds aggressively
i. selective price cuts
ii. denies connection to
iii. regulators suppress competition
3. Policy
a. early
antitrust suits result in minor conduct agreements
b. FCC rule
changes
i. competing equipment can be connected to system
ii. long distance service
-MCI, Sprint (gradual entry after 1970)
c. Section 2
monopolization case filed 1974
i. long expensive case
ii. Judge rules probable antitrust violation
iii. AT&T agrees to break-up (1982)
4. Divestiture
a. largest
antitrust break-up
b. AT&T:
Bell Labs, Western Electric, Long distance
c. Regional
Bell Operating Companies (RBOC)
i. local phone service
ii. 7 independent "Baby Bells"
-
d. effects
of break-up
i. quality remained high
ii. long distance prices fell substantially
- MCI and Sprint gain market share by cutting price
- prices and market share stabilize: tight oligopoly
iii. AT&T undergoes further restructuring
iv. local Bells prosper
v. innovation increases
F. Structural change
1. new
entry into long distance transmission
a. firms
specializing in data transfer
b. internet
backbone
c. Qwest,
WorldCom, and others
2. mergers
a. WorldCom
merges with MCI and later Sprint
b. Qwest
buys US West
c. RBOCs merge
i. SBC purchases most other RBOCs
ii. SBC purchases AT&T (and re-names itself at&t)
3. Development of cell phone industry
4. Telecommunications Act of 1996
a. opened
local markets to competition
i. Competitive Local Exchange
Carriers
ii. CLEC
b. allowed RBOCs to sell long distance service, once local competition
was established
G. Current conditions
1. rapid
demand growth (data/internet)
2. long
distance transmission grew rapidly
3. local
phone connections lagged
a.
continuing near monopoly
b. potential
entrants eliminated by mergers
4. technological
substitutes may provide future competition
a. VOIP
b. fixed
wireless
c. cellular
service
d. cable
5. convergence?
A. Economies of scale
1. brewing:
dimensional economies
2. bottling
3. small
breweries (1-2 million barrels/year) face substantially higher costs than a 4
million brewery
4. modest
additional cost savings out to 8 million barrels/year
B. Transportation cost
1. originally
many small local brewers
2. technological
change allows national shipping
a.transportation
cost: original source of price premium for shipping brewers
b. premium
image developed
c.
belief: high price = high quality
d.
brand image advantage to early shippers
C. Structural change
1. multiplant production
a. lower
transportation costs for national brewers
b. premium
image remains
c. higher
profits-- more advertising
2. local
and regional brewers squeezed out
3. market
concentration increases substantially
a. Herfindahl index increases from H = 140 (1947) to H = 2789
(1998)
b. tight
oligopoly
D. Merger Policy
1.Clayton Act (1914)
a. Section 7
b. restricts mergers
c. prohibits mergers
that substantially lessen competition
2. Celler- Kefauver Act (1950)
3. merger
guidelines (DOJ)
a. significant
increases in market concentration lessen competition
b. challenges based on
Herfindahl index
i. highly concentrated markets (H> 1800) (change >
50)
ii.
moderately concentrated markets (1800>H>1000)
(change H > 100)
iii. unconcentrated markets
(H<1000) challenge unlikely
4. market
definition
a. product market
b. geographic market
c. definitions key to
antitrust merger cases
5. Failing firm defense
E. Beer mergers
1. Anheuser Bush and American Brewing Co
(
a. court requires sale
b. court restricts
future mergers by Anheuser Bush for 5 years
2. Pabst and Blatz
(1958)
a. court orders sale
of Blatz (1959)
b. Heileman
buys remaining Blatz assets
3. national leaders
(A-B, Miller, Coors) grow by building new breweries
4. regional and local
mergers allowed
a. locals unable to
compete
b. failing firm
defense
5. Consolidation
a. Heileman
acquires over a dozen brewers
b. Stroh acquires
Schafer, Schiltz, Heileman
then fails
c. Miller and Pabst
split Stroh's brands and assets
d. Pabst contracts all
brewing to other manufacturers
e. minor impact on
market concentration
- mergers were an exit strategy for failing firms
F. Product differentiation
1. most
American beer has a similar mild flavor (horizontal differentiation)
2. in blind
taste tests, consumers can not distinguish brands
3. but,
consumers are willing to pay more for premium brands (vertical differentiation)
4. high
cost is high quality?
5. advertising
a.
reinforces brand image
b. significant
cost to brewers
c. optimal
amount of advertising
i. elasticity of demand with respect to ads
- higher advertising elasticity = more ads
- higher profit = more ads
d. economies
of scale
e. barrier
to entry?
6. Trademark
a. intellectual property: name,
symbol, device
b. bought, sold, licensed
c. international conflicts
G. International aspects of the beer industry
1. Imports grow substantially
a. transportation
costs lead to higher price
b. premium image
develops
2.
3. International
mergers
a. SAB Miller (2002)
b. Interbrew
AmBev (2004)
c. Molson Coors (2005)
d. InBev
– Anheuser-Busch
4. global
brewers
5. brand
licenses, joint ventures and foreign investment
H. Craft beers
1. microbreweries
a. very high costs due
to suboptimal scale
b. product differentiation
from strong flavor
c. many avoid
transportation costs and advertising costs
d. high prices and
super-premium image
2. contract
brewing
a. make use of over
capacity of regional brewers
b. costs above
national brewers, less than microbreweries
c. superpremium
image
3. Substantial growth
4. national
firms imitate style
a. Red Dog/ Ice House
(Miller)
b. Kilian's
Red (Coors)
5. wide range of
consumer choices
IV Industrial Organization and Public
Policy
Industrial Organization and Public Policy