What is IO about: An Example

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What is IO about An Example
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• Galxo Wellcome is one of the leading
  pharmaceutical company. Its main product, Zantac,
  is a popular ulcer and heartburn medicine.
• It costs relatively little to produce Zantac, but
  Galxo Wellcome sell it at a very high price.
• Question Why Galxo Wellcome can charge a price
  without losing a significant number of customers?

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What is IO about An Example

• One answer legal protection. Galxo Wellcome
  holds a number of patents that protect its
  blockbuster drug.
• But the legal protection enjoyed by Galxo
  Wellcome is ending. And there are several close
  substitutes in the same market Tagamet produced
  by SmithKline and generic Zantac by other
  companies.
• Doctor Branded Zantac and generic Zantac have
  the same effect.

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What is IO about An Example

• The price of Zantac is much higher than generic
  Zantac. 30 tablet box of Zantac, 90 250 tablet
  box of generic Zantac, 95.
• Question without much legal protection, how can
  Zantac be sold at a such high price?
• Answer Glaxo Wellcome spend hundreds of millions
  of dollars in advertising. Zantac enjoys brand
  loyalty from consumers and doctors.

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What is IO about An Example

• Key The inner quality of the product doesnt
  matter so much what matters is consumers
  perception of the product. Advertising can
  influence consumers perception, thus
  establishing brand loyalty.
• How Zantac came into being?
• Back to late 70s, Glaxo and Wellcome are two
  independent companies. And the dominant firm in
  the market is SmithKline, with Tagamet as the
  most popular drug in the field.

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What is IO about An Example

• Glaxo is strong in respiratory and
  gastrointestinal medications while Wellcome is
  strong in antiviral remedies. Their strengths are
  complementary.
• Glaxo and Wellcome merged to form Glaxo Wellcome.
  The merger creates synergies. And Zantac is one
  of its fruits. Combining with effective
  advertising, Zantac become the most popular drug
  among ulcer an heartburn medicine.

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Summary of The Example

• Glaxo Wellcome enjoys a significant degree of
  market power.
• Glaxo Wellcome gained market power through a
  clever merger and an aggressive marketing
  strategy.
• For a time, Zantacs position was protected by
  patent rights. This is no longer the case now
  differentiating the product from generic products
  becomes the priority.

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Central Questions in IO (I)

• Is there Market Power?
• Definition Market power is the ability to set
  prices above marginal cost.
• For some markets, yes. For some markets, no.

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Is There Market Power?

• Example 1
• Among 43 large airports in US., 10 of them are
  controlled by one or a few airlines. At these
  airports, on average fliers were paying 31 more
  than at the remaining airports.

• Example 2
• The prices of office supplies. In areas where
  only one chain (say, Staples or Office Depot)
  operates, prices can be up to 15 higher than in
  other areas.

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Is There Market Power?

• Chicago School opinion
• As long as there is free entry into each
  industry, the extent of market power is never
  significant.
• If a firm were to persistently set prices above
  cost, a new firm would find it profitable to
  enter the market and undercut the incumbent.

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Central Questions in IO (II)

• How do firms acquire market power?
• Patent. In 1960s, Xerox invented plain-paper
  photocopying and patented it.
• Marketing strategy. (see the example of the next
  slide)

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How do firms acquire market power (an example)

• British Sky Broadcasting Group (BSkyB) and
  Ondigital are competitors for the British digital
  TV market. In 1999, BSkyB introduced an
  aggressive package that includes a free set-top
  decoder box, free internet access and a 40
  discount on telephone charges.

• Intention
• preempt its rivals by creating an early lead in
  installed base of subscribers.
• Result
• BSkyBs shares were up by 12, whereas
  Ondigitals slid by 1.8

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How do firms maintain market power

• Market conditions are changing patents expire
  imitation takes place protected industries are
  deregulated
• Incumbents usually use marketing strategies to
  maintain market power.

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How do firms maintain market power( an example)

• American Airlines (AA) is the Dominant airline at
  Dallas/Forth Worth hub. When one of the
  competitors, Vanguard entered the market, AA
  decreased its air fares.
• The fare between Dallas and Kansas City, fell
  from 108 to 80.
• After Vanguard exited, AA gradually raised the
  fare to up to 147 in 1996.

• The excessively low fares charged by AA was
  intended to drove its competitors out of the
  market and enjoy higher profits later.
• Moreover, AA developed a reputation of toughness,
  which discourages future potential entrant to
  enter.

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Question (III) What are the implications of
market power?

• Allocative inefficiency
• Overall, firms increase in profit is less than
  the loss of consumers surplus. Deadweight loss
  is the result.
• The quantity sold will be less than the efficient
  one.

• Distributional effect
• Firms profits increases.
• Consumers surplus decreases

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More implications of market power

• Productive inefficiency
• Competition encourages firms to reduce costs.
  Less competition (more market power) reduces
  firms incentive to innovate.
• European airlines (regulated) are less efficient
  than American airlines (deregulated).

• Rent seeking
• If market power is created by government
  intervention (regulation), then firms may spend
  unproductive resources to influence policymakers
  and gain market power.

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An opposite view

• Austrian School (Schumpeter)
• Large companies (resulting in market power) is a
  good thing only they have the ability to
  mobilize substantial amount of resources to
  invent new technology. Market power is a
  precondition for technological progress.

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Question (IV) What can government do?

• Regulation
• It applies to firms which detains monopoly or
  near-monopoly power.
• Example Until 1996, ATT needed the approval of
  regulating agency each time it changed its
  long-distance telephone fares.

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Question (IV) What can government do?

• Antitrust policy
• Prevent firms from taking actions that increase
  market power in a detrimental way.
• List of suspicious actions
• collusion
• predatory pricing
• bundling (Microsoft Vs Netscape case)

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Chicago School View

• Market power doesnt exist without government
  intervention.
• It is government regulation that creates market
  power. (rent-seeking and corruption).

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Two approaches to IO

• Structure-conduct-performance (SCP) paradigm.
• Dominated research before late 1970s.

• Game theory.
• driven the theoretical research in IO since late
  1970s.
• Strategic interactions capture the essence of
  imperfect competition.

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SCP Paradigm

• Market structure (number of sellers, degree of
  product differentiation) determines the conduct
  of firms (pricing, advertising,)
• Firms conducts determines industry and firm
  performance (profits, efficiency).

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Game Theory (I)

• A Game describes situations of strategic
  interaction, where the payoff for one agent
  depends on its own actions as well as on the
  actions of other agents.
• Example. In an industry consisting of 2 firms,
  each firms profit depends not only on its own
  price but also on the price charged by the other
  firm.

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Prisoners dilemma

• 2 suspects committed a crime together and were
  caught by police.
• Police are lacking of evidence to convict them.
• They are confined in two separate rooms and are
  asked to confess.
• Each suspect has two choices confess (C) or not
  confess (N).

• The payoff of the game is following (measured by
  number of years in jail)

Suspect 2
N
C
-6,0
-1,-1
N
Suspect 1
0,-6
-5,-5
C
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Elements of a game

• A set of players
• A set of rules (who can do what when)
• A set of payoff functions (the utility each
  player gets as a result of each possible
  combination of strategies)

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Normal form representation

• The matrix representation of a game, like the
  matrix of slide 23, is known as normal form
  representation.
• In the prisoners dilemma game, both players
  choose their strategies simultaneously
  for each player, when he choose his strategy he
  does not know the choice of other player.

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Dominant strategy

• Definition whenever a player has a strategy that
  is strictly better than any other strategy
  regardless of the other players strategy
  choices, we say that the first player has a
  dominant strategy.

• In the prisoners game, C is dominant strategy
  for each player.
• Rational player will play his dominant strategy.

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Dominated strategy

• Definition whenever a player has a strategy that
  is strictly inferior to any other strategy
  regardless of the other players strategy
  choices, we say that the first player has a
  dominated strategy.

• N is the dominated strategy for each player in
  prisoners dilemma game.
• A rational player will never play a dominated
  strategy.
• Iterated elimination of dominated strategies.

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Battle of sex

• Dominant strategy or iterated elimination of
  dominated strategy may not pin down (or predict)
  how the game will be played.
• Example Battle of sex.

• A husband and a wife want to go out on a Friday
  night, each of them can choose go to boxing (B)
  or concert (C).

wife
B
C
2,1
0,0
B
husband
0,0
1,2
C
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Nash equilibrium

• In the game of Battle of sex, there is no
  dominant strategy or dominated strategy.
• Another equilibrium concept Nash equilibrium
• Definition Nash equilibrium is a pair of
  strategies such that no player can unilaterally
  change its strategy in a way that improves its
  payoff.

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Nash Equilibrium

• In prisoners dilemma, (C,C) is a Nash
  Equilbrium.
• The game of prisoners dilemma applies to a
  broad issues in IO. For example, advertising
  game.
• In battle of sex, (B, B) and (C, C) are both
  Nash equilibria.

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Nash equilibrium

• Nash equilibrium always exists. (possibly in
  mixed strategies).

• Battle of sex is one of the games in a large
  class, coordination games.
• Many other games in IO have similar structure.
  For example, standardization game.