Ⅰ Foundations 1
1 Introduction 3
1.1 A More Formal Introduction to IO 7
1.1.1 The Demand for Industrial Organization 10
1.2 Methodologies 10
1.2.1 The New Industrial Organization 10
1.2.2 The Theory of Business Strategy 11
1.2.3 Antitrust Law 12
1.3 Overview of the Text 12
1.3.1 Foundations 12
1.3.2 Monopoly 12
1.3.3 Oligopoly Pricing 13
1.3.4 Strategic Behavior 14
1.3.5 Issues in Antitrust Economics 15
1.3.6 Issues in Regulatory Economics 16
1.4 Suggestions for Further Reading 16
2 The Welfare Economics of Market Power 19
2.1 Profit Maximization 20
2.2 Perfect Competition 21
2.2.1 Supply 22
2.2.2 Market Equilibrium 23
2.3 Efficiency 25
2.3.1 Measures of Gains from Trade 25
2.3.2 Pareto Optimality 28
2.4 Market Power 29
2.4.1 Market Power and Pricing 31
2.4.2 Measurement and Determinants of Market Power 36
2.4.3 The Determinants of Deadweight Loss 37
2.5 Market Power and Public Policy 40
2.6 Chapter Summary 42
2.7 Suggestions for Further Reading 43
3 Theory of the Firm 49
3.1 Neoclassical Theory of the Firm 50
3.1.1 Review of Cost Concepts 52
3.1.2 The Potential Advantages of Being Large 54
3.1.3 Economies of Scale and Seller Concentration 60
3.2 Why Do Firms Exist? 62
3.2.1 Two Puzzles Regarding the Scope of a Firm 62
3.2.2 Explanations for the Existence of Firms 63
3.2.3 Alternative Economic Organizations 65
3.2.4 Spot Markets 65
3.2.5 Specific Investments and Quasi-Rents 69
3.2.6 Contracts 72
3.2.7 Complete vs.Incomplete Contracts 73
3.2.8 Vertical Integration 76
3.3 Limits to Firm Size 81
3.3.1 The Paradox of Selective Intervention 82
3.3.2 Property Rights Approach to the Theory of the Firm 84
3.4 Do Firms Profit Maximize? 94
3.4.1 Shareholder Monitoring and Incentive Contracts 95
3.4.2 External Limits to Managerial Discretion 98
3.5 Chapter Summary 101
3.6 Suggestions for Further Reading 102
Ⅱ Monopoly 109
4 Market Power and Dominant Firms 111
4.1 Sources of Market Power 113
4.1.1 Government Restrictions on Entry 116
4.1.2 Structural Characteristics 118
4.1.3 Strategic Behavior by Incumbents 123
4.2 A Dominant Firm with a Competitive Fringe 124
4.2.1 The Effect of Entry 129
4.3 Durable Goods Monopoly 130
4.3.1 The Coase Conjecture 130
4.3.2 Pacman Economics 141
4.3.3 Coase vs.Pacman 143
4.3.4 Recycling 144
4.4 Market Power:A Second Look 145
4.4.1 X-Inefficiency 145
4.4.2 Rent Seeking 147
4.5 Benefits of Monopoly 148
4.5.1 Scale Economies 148
4.5.2 Research and Development 148
4.6 Chapter Summary 149
4.7 Suggestions for Further Reading 150
5 Non-Linear Pricing and Price Discrimination 155
5.1 Examples of Price Discrimination 156
5.2 Mechanisms for Capturing Surplus 158
5.3 Market Power and Arbitrage:Necessary Conditions for Price Discrimination 160
5.4 Types of Price Discrimination 161
5.4.1 First-Degree Price Discrimination 162
5.4.2 Third-Degree Price Discrimination 164
5.4.3 Second-Degree Price Discrimination 166
5.4.4 General Non-Linear Pricing 170
5.4.5 Optimal Non-Linear Pricing 173
5.5 Antitrust Treatment of Price Discrimination 177
5.6 Chapter Summary 178
5.7 Suggestions for Further Reading 179
6 Market Power and Product Quality 183
6.1 Search Goods 185
6.1.1 Monopoly Provision of Quality 186
6.1.2 Quality Discrimination 189
6.2 Experience Goods and Quality 190
6.2.1 Moral Hazard and the Provision of Quality 191
6.2.2 The Lemons Problem 191
6.3 Signaling High Quality 193
6.3.1 A Dynamic Model of Reputation for Quality 193
6.3.2 Advertising as a Signal of Quality 196
6.3.3 Warranties 199
6.4 Chapter Summary 202
6.5 Suggestions for Further Reading 203
6.6 Appendix:The Complete Model of Quality Discrimination 206
Ⅲ Oligopoly Pricing 209
7 Game Theory Ⅰ 211
7.1 Why Game Theory? 212
7.2.3 Equilibrium Concepts 215
7.2.2 Types of Games 215
7.2.1 The Basic Elements of a Game 215
7.2 Foundations and Principles 215
7.2.4 Fundamental Assumptions 216
7.3 Static Games of Complete Information 216
7.3.1 Normal Form Representation 216
7.3.2 Dominant and Dominated Strategies 217
7.3.3 Rationalizable Strategies 219
7.3.4 Nash Equilibrium 220
7.3.5 Discussion and Interpretation of Nash Equilibria 221
7.3.6 Mixed Strategies 225
7.4 Chapter Summary 226
7.5 Suggestions for Further Reading 227
7.6 Appendix:Nash Equilibrium in Games with Continuous Strategies 230
8 Classic Models of Oligopoly 231
8.1 Static Oligopoly Models 232
8.2 Cournot 233
8.2.1 Cournot Best-Response Functions and Residual Demand Functions 234
8.2.2 Properties of the Cournot Equilibrium 238
8.2.3 Free-Entry Cournot Equilibrium 247
8.2.4 The Efficient Number of Competitors 249
8.3 Bertrand Competition 256
8.3.1 The Bertrand Paradox 256
8.3.2 Product Differentiation 258
8.3.3 Capacity Constraints 264
8.4 Cournot vs.Bertrand 270
8.5.1 Conjectural Variations 272
8.5 Empirical Tests of Oligopoly 272
8.6 Chapter Summary 274
8.7 Suggestions for Further Reading 275
8.8 Appendix:Best-Response Functions,Reaction Functions,and Stability 279
8.8.1 Stability 281
8.8.2 Uniqueness 282
9 Game Theory Ⅱ 283
9.1 Extensive Forms 284
9.2 Strategies vs.Actions and Nash Equilibria 286
9.3 Noncredible Threats 287
9.3.1 Subgame Perfect Nash Equilibrium 287
9.3.2 The Centipede Game 290
9.4 Two-Stage Games 291
9.5.1 Finitely Repeated Stage Game 292
9.5 Games of Almost Perfect Information 292
9.5.2 Infinitely Repeated Stage Game 293
9.6 Chapter Summary 299
9.7 Suggestions for Further Reading 299
9.8 Appendix:Discounting 303
10 Dynamic Models of Oligopoly 305
10.1 Reaching an Agreement 308
10.1.1 Profitability of Collusion 314
10.1.2 How Is an Agreement Reached? 314
10.1.3 Factors That Complicate Reaching an Agreement 318
10.2 Stronger,Swifter,More Certain 328
10.3 Dynamic Games 329
10.3.1 Credible Punishments and Subgame Perfection:Finite Games 329
10.4 Supergames 331
10.4.1 Subgame Perfection and Credible Threats:Infinite Game 332
10.4.2 Harsher Punishment Strategies 334
10.4.3 Renegotiation Proof Strategies 340
10.5 Factors That Influence the Sustainability of Collusion 340
10.6 Facilitating Practices 348
10.6.1 Efficiency and Facilitating Practices 355
10.7 Antitrust and Collusion 355
10.8 Chapter Summary 357
10.9 Suggestions for Further Reading 358
11 Product Differentiation 367
11.2 Monopolistic Competition 369
11.2.1 Preference Specification 369
11.1 What Is Product Differentiation? 369
11.2.2 Monopolistic Competition:Equilibrium 370
11.2.3 Too Many Brands of Toothpaste? 373
11.3 Bias in Product Selection 376
11.3.1 Asymmetric Preferences 376
11.4 Address Models 379
11.4.1 Consumer Preferences 380
11.4.2 A Simple Address Model:Hotelling s Linear City 381
11.4.3 Free Entry into the Linear City 384
11.4.4 Localized Competition 391
11.4.5 Efficiency of the Market Equilibrium 391
11.4.6 Endogenous Pricing 395
11.4.7 Pricing and the Principle of Minimum Differentiation 402
11.5.1 Brand Proliferation 404
11.5 Strategic Behavior 404
11.5.2 Brand Specification 407
11.5.3 Brand Preemption 407
11.6 Oligopoly Equilibrium in Vertically Differentiated Markets 411
11.7 Chapter Summary 413
11.8 Suggestions for Further Reading 415
12 Identifying and Measuring Market Power 423
12.1 Structure,Conduct,and Performance 425
12.1.1 SCP in Practice:The Framework 426
12.1.2 SCP in Practice:The Results 431
12.1.3 Critiques of SCP Studies 432
12.2 The New Empirical Industrial Organization 440
12.2.1 Structural Models 440
12.2.2 Nonparametric,or Reduced-Form,Approaches 451
12.3 The NEIO and SCP:A Summing Up 452
12.4 Chapter Summary 452
12.5 Suggestions for Further Reading 454
Ⅳ Strategic Behavior 457
13 An Introduction to Strategic Behavior 459
13.1 Strategic Behavior 461
13.1.1 Strategic vs.Tactical Choices 465
13.2 The Stackelberg Game 467
13.2.1 Stackelberg Equilibrium 468
13.3 Entry Deterrence 473
13.3.1 Constant Returns to Scale 473
13.3.2 Economies of Scale 474
13.4 Introduction to Entry Games 478
13.4.1 Limit Pricing 478
13.4.2 A Stylized Entry Game 479
13.5 Chapter Summary 481
13.6 Suggestions for Further Reading 482
14 Entry Deterrence 485
14.1 The Role of Investment in Entry Deterrence 487
14.1.1 Dixit s Model of Entry Deterrence 488
14.1.2 Strategic Investment and Monopolization 504
14.2 Contestable Markets 507
14.2.1 Logical Possibility 509
14.2.2 Robustness 510
14.2.3 Empirical Relevance 512
14.2.4 Contestability and Barriers to Entry 512
14.3.1 Positive Definitions of Barriers to Entry 513
14.3 Entry Barriers 513
14.3.2 An Assessment of Barriers to Entry 514
14.3.3 Normative Definitions of Entry Barriers 517
14.4 Chapter Summary 518
14.5 Suggestions for Further Reading 519
15 Strategic Behavior:Principles 525
15.1 Two-Stage Games 526
15.2 Strategic Accommodation 532
15.3 Strategic Entry Deterrence 535
15.4 The Welfare Effects of Strategic Competition 538
15.5 Chapter Summary 539
15.6 Suggestions for Further Reading 540
16.1 Learning by Doing 543
16 Strategic Behavior:Applications 543
16.1.1 Learning with Price Competition 546
16.1.2 Learning and Entry Deterrence 546
16.2 Switching Costs 546
16.2.1 Strategic Manipulation of an Installed Base of Customers 547
16.2.2 Incorporating New Buyers 549
16.2.3 Endogenous Switching Costs 549
16.3 Vertical Separation 550
16.4 Tying 551
16.5 Strategic Trade Policy Ⅰ:Export Subsidies to Regional Jets 552
16.6 Strategic Trade Policy Ⅱ:The Kodak-Fujifilm Case 553
16.7 Managerial Incentives 554
16.8 Research and Development 555
16.10 Chapter Summary 556
16.9 The Coase Conjecture Revisited 556
16.11 Suggestions for Further Reading 557
17 Advertising and Oligopoly 561
17.1 Normative vs.Positive Issues:The Welfare Economics of Advertising 562
17.2 Positive Issues:Theoretical Analysis of Advertising and Oligopoly 563
17.2.1 Advertising as an Exogenous Sunk Cost 563
17.2.2 Advertising as an Endogenous Sunk Cost 565
17.2.3 Cooperative and Predatory Advertising 566
17.3 Advertising and Strategic Entry Deterrence 567
17.4 A More General Treatment of Strategic Advertising:Direct vs.Indirect Effects 567
17.5 Positive Issues:Advertising and Oligopoly Empirics 569
17.6 Chapter Summary 571
17.7 Suggestions for Further Reading 571
18 Research and Development 575
18.1 A Positive Analysis:Strategic R＆D 577
18.2 Market Structure and Incentives for R＆D 578
18.2.1 A More Careful View of Market Structure 581
18.2.2 Patent Races 582
18.2.3 Stochastic Patent Races 585
18.2.4 Product Innovation and Patent Races 586
18.3 Normative Analysis:The Economics of Patents 588
18.3.1 Other Forms of Intellectual Property Protection:Copyrights and Trademarks 591
18.4 Chapter Summary 592
18.5 Suggestions for Further Reading 593
Ⅴ Issues in Antitrust Economics 597
19 The Theory of the Market 599
19.1.1 Economic Markets 601
19.1 The Concept of a Market 601
19.1.2 Antitrust Markets 602
19.2 Antitrust Markets:The Search for Market Power 603
19.2.1 Market Power and Antitrust 603
19.2.2 Market Power and Market Shares 604
19.2.3 The Importance of Demand Elasticities 605
19.2.4 Critical Elasticities of Demand 607
19.2.5 Break-Even Elasticities of Demand 608
19.2.6 Recent Developments:Innovation Markets 612
19.3 The Practice of Market Definition 612
19.3.1 Demand Elasticities 612
19.3.2 The Structural Approach 613
19.3.4 Qualitative Evaluative Criteria 616
19.3.3 Shipment Flows 616
19.4 Antitrust Markets in Monopolization Cases:The Cellophane Fallacy 617
19.4.1 The Cellophane Fallacy and Mergers 618
19.5 Chapter Summary 618
19.6 Suggestions for Further Reading 619
20 Exclusionary Strategies Ⅰ: Raising Rivals Costs 625
20.1 A Simple Model of Raising Rivals Costs 626
20.2 The Salop and Scheffman Model:Raising the Costs of a Competitive Fringe 628
20.3 Accommodation vs.Deterrence Strategies 630
20.4 A More General Treatment of Raising Rivals Costs:Direct vs.Indirect Effects 634
20.5 Reducing Rivals Revenue 635
20.6 Raising Rivals Costs in Antitrust 639
20.7 Chapter Summary 639
20.8 Suggestions for Further Reading 640
21 Exclusionary Strategies Ⅱ: Predatory Pricing 643
21.1 The Classic Chicago Attack on Predation 645
21.2 Rational Theories of Predation 647
21.2.1 The Long Purse 648
21.2.2 Reputation Models 649
21.2.3 Signaling Models of Predation 653
21.2.4 Softening Up the Victim 653
21.2.5 Predation in Learning and Network Industries 653
21.3 Empirical Evidence on Predation 654
21.3.1 Case Studies 655
21.3.2 Experimental Evidence 658
21.4 Predation in Antitrust 659
21.4.1 Areeda-Turner and Cost-Based Definitions of Predation 659
21.4.2 Major Antitrust Cases 661
21.5 Chapter Summary 662
21.6 Suggestions for Further Reading 662
21.7 Appendix:An Introduction to Games of Incomplete Information 670
21.7.1 Bayesian Games 670
21.7.2 Extensive-Form Bayesian Games with Observable Actions 672
21.7.3 Multiple but Finite Numbers of Victims in the Extortion Game 677
22 Vertical Integration and Vertical Restraints 683
22.1 Incentives for Vertical Merger(Vertical Integration) 684
22.1.1 Transaction Economies 684
22.1.2 Vertical Integration to Avoid Double Marginalization 685
22.1.3 Vertical Integration with Perfect Competition Downstream:Fixed Proportions 686
22.1.4 Vertical Integration with Perfect Competition Downstream:Variable Proportions 687
22.2 Vertical Restraints 688
22.2.1 Restraints on Intrabrand Competition 690
22.2.2 Alternative Explanations of RPM and Exclusive Territorial Restrictions 694
22.2.3 RPM,Exclusive Territories,and Welfare 694
22.2.4 Antitrust Policy toward RPM and Exclusive Territories 695
22.3 Contractual Exclusivity 696
22.3.1 Tying Arrangements 696
22.3.2 Exclusive Dealing 704
22.4 Chapter Summary 707
22.5 Suggestions for Further Reading 708
22.6 Appendix:Price versus Non-Price Competition in the Winter Model 711
23 Horizontal Mergers 715
23.1 A Partial-Equilibrium Analysis of Horizontal Mergers 717
23.1.2 The Use of the Herfindahl Index in Merger Analysis 718
23.1.1 Price versus Efficiency:The Williamson Trade Off 718
23.2 Equilibrium with Nonmerging Firms:A More General Analysis 720
23.2.1 Mergers in Differentiated Markets 722
23.3 The Coordinated Effects of Mergers 724
23.4 Entry 725
23.5 Mergers:The Antitrust Framework 726
23.5.1 Merger Guidelines 726
23.5.2 Market Definition 726
23.5.3 Innovation Markets 727
23.5.4 Entry and Product Repositioning 728
23.5.5 Efficiencies:A Growing Emphasis 729
23.5.6 Methodology:The Growing Role of Simulation in Antitrust Analysis 732
23.6 Chapter Summary 738
23.7 Suggestions for Further Reading 739
23.8 Appendix:Bertrand Equilibrium with Three Differentiated Products 741
Ⅵ Issues in Regulatory Economics 745
24 Rationale for Regulation 747
24.1 Public Interest Justifications for Regulatory Intervention 750
24.1.1 The Market Failure Test 752
24.1.2 Natural Monopoly 752
24.1.3 Large Specific Investments 765
24.2 The Economic Theories of Regulation 769
24.2.1 The Theory of Economic Regulation 769
24.2.2 Explaining Regulation Using a Principal-Agent Approach 772
24.3 Chapter Summary 775
24.4 Suggestions for Further Reading 777
24.5 Appendix:Subadditivity and Multiproduct Firms 781
25 Optimal Pricing for Natural Monopoly 785
25.1 Efficient Pricing by a Single-Product Natural Monopolist 786
25.1.1 First-Best Pricing 786
25.1.2 Second-Best Pricing:Ramsey Prices 788
25.1.3 First-vs.Second-Best Pricing 788
25.2 Multiproduct Natural Monopoly 788
25.2.1 Ramsey Pricing 789
25.3 Peak-Load Pricing 801
25.3.1 A Simple Illustrative Model of Peak-Load Pricing 802
25.3.2 Optimal Capacity 806
25.3.3 Discussion of Peak-Load Pricing 808
25.4 Multipart Tariffs 810
25.4.1 Two Common Examples of Multipart Tariffs 812
25.4.2 The Coase Result 814
25.4.3 N-Part Tariffs and a Menu of Two-Part Tariffs 817
25.4.4 Pareto-Dominating Block Tariffs 817
25.5 Chapter Summary 821
25.6 Suggestions for Further Reading 822
26 Issues in Regulation 829
26.1 Regulation under Asymmetric Information 831
26.1.1 The Full-Information Benchmark 831
26.1.2 Asymmetric Information:The Importance of Distributional Considerations 833
26.1.3 An Optimal Regulatory Mechanism:Hidden Information 834
26.1.4 An Optimal Regulatory Mechanism:Hidden Action 838
26.1.5 Implications for Regulatory Regimes 839
26.2 Regulation in Practice 840
26.2.1 Cost-of-Service Regulation 841
26.2.2 An Assessment of COS Regulation 847
26.2.3 Summary of Cost-of-Service Regulation 852
26.2.4 Incentive Regulation 852
26.2.5 Guidelines for Regulation 860
26.3 Regulatory Reform in Network Industries 861
26.3.1 Why Regulated Firms Should Be Kept Out of Unregulated Markets 863
26.3.2 Access Pricing and Interconnection 871
26.3.3 The Interconnection Problem 871
26.3.4 The Efficient Component Pricing Rule 872
26.3.5 Optimal Access Pricing 873
26.4 Chapter Summary 877
26.5 Suggestions for Further Reading 879
A.1.1 The Sherman Act 889
A.1 Antitrust in the United States 889
Appendix The Legal Framework of Antitrust Enforcement 889
A.1.2 The Clayton Act 891
A.1.3 Enforcement in the U.S 891
A.2 Competition Policy in Canada 895
A.2.1 Criminal Provisions in the Competition Act 895
A.2.2 The Director of Research and Investigation 896
A.2.3 Noncriminal Reviewable Offenses 896
A.3 Competition Policy of the European Union 897
A.3.1 Enforcement in the EU 898
A.4 Suggestions for Further Reading 899
Selected Solutions for Odd Numbered Questions 901
Index of Names 909
Subject Index 915