MASTER PROGRAMS Fall Semester 2008/2009

COURSE SYLLABUS

THEORY OF INDUSTRIAL ORGANIZATION Instructor: Dr Igor Baranov, Associate Professor, [email protected] Organization of the course Program Year Course status Workload Prerequisites Teaching methods

Master in International Business 1-st year Elective 3 ECTS, 30 hours of classes Introductory Microeconomics Lectures, group work, presentations, case study, home and class assignments

Course objectives  

To study the operation and performance of imperfectly competitive markets and the behavior of firms in these markets To determine factors and strategies that provide firms with a competitive advantage, with a special focus on identifying strategies which create monopoly rents and allow firms to maintain them

Course content Topic 1. Introduction to Industrial Organization Description of Industrial Organization. Different approaches to studying Industrial Organization. Characteristics of perfect competition. Market equilibrium and the zero profit condition. Monopoly (market) power and downward sloping demand. Equilibrium and positive economic profit. Efficiency comparisons of competition and monopoly using surplus concepts. Measures of Market Structure. Concentration Curves and Ratios. Herfindahl Index. Measurement Problems. Measures of Market Power. Lerner Index. Empirical Measures of Monopoly-Induced Market Distortions. Economies of size and scale. Fixed, sunk, avoidable, and variable costs. Basic structure of multiproduct firms Topic 2. Price Discrimination Uniform versus non-uniform pricing. Feasibility of Price Discrimination. Third degree price discrimination. Third degree price discrimination for differentiated products. First degree price -1-

discrimination. Two-part tariffs and block pricing. Idea and prevalence of volume discounts. Second degree price discrimination. Incentive compatible pricing schemes. Topic 3. Product Differentiation and Product Quality Vertical versus horizontal price differentiation. Spatial model of product differentiation (Hotelling). Vertical Product Differentiation. Offering more than one product in a Vertically Differentiated Market. Product tie-ins and commodity bundling. Commodity bundling as a way to price discriminate. Complementary goods and network externalities. Damaged goods. Topic 4. Oligopoly and Strategic Interaction Simultaneous (normal) and sequential (extensive) form games. Dominant and dominated strategies. Nash equilibrium as a solution concept. Finding Nash equilibrium. Best response functions. Oligopoly models. The simple Cournot model. The Bertrand Model. Strategic substitutes / complements. Simultaneous vs. Sequential Games. Stackelberg model. Credibility, credible commitments. Topic 5. Oligopoly: Entry Deterrence Predatory conduct and credible threats. Limit pricing in incumbent/entrant (Stackelberg) models. Predation in incumbent/entrant (Stackelberg) models. Extensive form games. Subgames in extensive form games and subgame perfection. Capacity expansion as a form of credible commitment. Predatory pricing. Role of contracts in impeding entry into a market. Public policy towards predatory behavior. Topic 6. Horizontal and Vertical Relations between Firms. Mergers Introduction to Stackelberg model of mergers. Gains from vertical integration. Oligopolistic vertical mergers. Conglomerate mergers. Topic 7. Strategic Investment and Nonprice Competition Types of innovations, market structure, and competition in R&D. The Schumpeterian hypothesis. Competition via innovation. Costs and benefits of advertising. Empirical facts on advertising (pricing) and quality. Advertising and monopoly power.

Plan of classes Topic 1. Introduction to Industrial Organization Class 1. September 3 1 pm – 4:15 pm Auditorium 408

Key points:  Description of Industrial Organization. Different approaches to studying Industrial Organization.  Characteristics of perfect competition. Market equilibrium and the zero profit condition. Monopoly (market) power and downward sloping demand. Equilibrium and positive economic profit. Efficiency comparisons of competition and monopoly using surplus concepts.  Measures of Market Structure. Concentration Curves and Ratios. Herfindahl Index. Measurement Problems. -2-

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Measures of Market Power. Lerner Index. Empirical Measures of Monopoly-Induced Market Distortions. Economies of size and scale. Fixed, sunk, avoidable, and variable costs. Basic structure of multiproduct firms Learning outcomes:  The Nature of Industrial Organization.  The motivation for formal analysis of imperfect competition.  Explain the characteristics of perfect competition  Graphically show the profit of a monopoly firm using the marginal revenue curve, the demand curve, the marginal cost curve, and the average total cost curve.  Explain the importance of firm size (production or sales potential) relative to market demand as it relates to monopoly power and market inefficiency.  Explain the following measures of structure: concentration ratios, Herfindahl-Hirschman index.  Explain the difference between a structure measure like CR4 and a performance measure like efficiency, profitability, or Pareto optimality.  Explain the issues related to the definition of a market and how this affects measures of concentration. The student will understand that an appropriate definition for one type of analysis may not be appropriate for another type of analysis and how aggregation can both clarify and cloud issues of market structure.  Understand the differences between the neoclassical (technological) view of the firm and other views related to agency theory, transactions costs, incomplete contracts, and residual control rights. The student will be able to discuss some of the limitations of the neoclassical approach in explaining the boundaries of the firm.  Explain economies of size and natural monopoly and how technology can affect industry structure.  Present a reasoned argument on various non-cost determinants of market structure. The student will be able to give examples of some of these determinants. Assignments for class 1:  Reading: Pepall, ch. 1-4; Church, ch. 1, 2, 3.1, 12; Porter “The Five Competitive Forces that Shape Strategy” Topic 2. Price Discrimination Class 2. September 11 1 pm – 4:15 pm Auditorium 408

Key points:  Uniform versus non-uniform pricing  Feasibility of Price Discrimination  Third degree price discrimination  Third degree price discrimination for differentiated products  First degree price discrimination  Two-part tariffs and block pricing  Idea and prevalence of volume discounts  Second degree price discrimination -3-

 Incentive compatible pricing schemes Learning outcomes:  Define and explain the differences between uniform pricing and price discrimination.  Explain the conditions that must exist for a firm to practice price discrimination.  Understand third degree price discrimination in the context of differentiated products.  Differentiate the three types of price discrimination.  Show how second-degree price discrimination leads to volume discounts and various ways to implement such discounts in a way to maximize profits. The student will be able to analyze block pricing schemes utilizing self-selection mechanisms. Assignments for class 2:  Reading: Pepall, ch. 5, 6; Church, ch. 5  Exercises: problems 1, 2 (see problem set) Topic 3. Product Differentiation and Product Quality Class 3. September 24 1 pm – 4:15 pm Auditorium 408

Key points:  Vertical versus horizontal price differentiation  Spatial model of product differentiation (Hotelling)  Vertical Product Differentiation  Offering more than one product in a Vertically Differentiated Market  Product tie-ins and commodity bundling  Commodity bundling as a way to price discriminate  Complementary goods and network externalities Learning outcomes:  Distinguish vertical from horizontal product differentiation.  Interpret physical space and distance as distance in product space in defining a spatial model of product differentiation.  Explain the extension of the model with one shop  Extend the analogy of price discrimination in geographic space to price discrimination in product characteristics space.  Distinguish commodity bundling (fixed proportions) from tie-in sales (variable proportions).  Distinguish pure and mixed bundling strategies and determine the optimal bundling strategy given data on reservation prices for different groups. Assignments for class 3:  Reading: Pepall, ch. 7-8; Church, ch. 6, 11  Exercises: problems 3, 4 (see problem set)

Topic 4. Oligopoly and Strategic Interaction Class 4. September 25 1 pm – 4:15 pm Auditorium 408

Key points:  Simultaneous (normal) and sequential (extensive) form games  Dominant and dominated strategies  Nash equilibrium as a solution concept -4-

 Finding Nash equilibrium  Best response functions  Oligopoly models  The simple Cournot model  The Bertrand Model  Strategic substitutes / complements  Simultaneous vs. Sequential Games  Stackelberg model  Credibility, Credible commitments Learning outcomes:  The student will understand the ideas of strategic interdependence and reasoning strategically and be able to apply them to economic models of market behavior.  The student will understand and be able to apply simple ideas from game theory to economic models.  The student will understand how to solve a simple Cournot duopoly model.  Understand the logic behind the Bertrand model of price competition, the idea of discontinuous reaction functions, how to solve a simple Bertrand duopoly model, and the fundamental differences between Bertrand and Cournot models.  Differentiate strategic substitutes and strategic complements.  Explain the difference between the Nash equilibrium of a simultaneous form game (Cournot) and an extensive form game (Stackelberg).  Gain an intuitive understanding of credibility, credible commitments, and credible threats. Assignments for class 4:  Reading: Pepall, ch. 9-11; Church, ch. 7-9  Exercises: problems 5, 6 (see problem set) Topic 5. Oligopoly: Entry Deterrence Class 5. October 1 1 pm – 4:15 pm Auditorium 408

Key points:  Predatory conduct and credible threats  Limit pricing in incumbent/entrant (Stackelberg) models  Predation in incumbent/entrant (Stackelberg) models  Extensive form games  Subgames in extensive form games and subgame perfection  Capacity expansion as a form of credible commitment  Predatory Pricing  Role of contracts in impeding entry into a market  Public Policy towards predatory behavior. Learning outcomes:  Define and give examples of predatory conduct.  Compare the potential returns from predation and from merger and analyze the incentives for particular types of strategies in different markets.  Utilize backward induction to solve extensive form games. The student will be able to prune extensive form game trees as a means for backward induction. -5-

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Differentiate predatory conduct, predatory pricing, and limit pricing. Assignments for class 5:  Reading: Pepall, ch. 12-13; Church, ch. 13, 14, 21  Exercises: problems 7, 8 (see problem set) Topic 6. Horizontal and Vertical Relations. Mergers Class 6. October 2 1 pm – 4:15 pm Auditorium 408

Key points:  Introduction to Stackelberg model of mergers  Gains from vertical integration  Oligopolistic vertical mergers  Conglomerate mergers Learning outcomes:  Explain the reasons behind mergers.  Differentiate horizontal, vertical, complementary, and conglomerate mergers.  Differentiate the conclusions of the alternative horizontal merger models (Cournot and multiple leader/follower Stackelberg) and relate them to the model assumptions.  Apply the complementary goods model to the analysis of vertical mergers.  Solve problems involving oligopolistic vertical mergers.  Relate scale and scope, transactions costs, proprietary information, and agency problems to incentives for conglomerate mergers. Assignments for class 6:  Reading: Pepall, ch. 16-17; Church, ch. 22-23  Exercises: problems 9, 10 (see problem set)

Topic 7. Strategic Investment and Nonprice Competition Class 7. October 8 1 pm – 4:15 pm Auditorium 408

Class 8. October 9 1 pm – 4:15 pm Auditorium 408

Key points:  Types of innovations, market structure, and competition in R&D  The Schumpeterian hypothesis  Competition via innovation  Costs and benefits of advertising Learning outcomes:  Discuss which types of industries are more likely to see research joint ventures.  Identify several ways in which advertising increases the demand for a product. Assignments for class 7:  Reading: Pepall, ch. 20, 22; Church, ch. 17-18

Key points:  Empirical facts on advertising (pricing) and quality  Advertising and monopoly power. -6-

Learning outcomes:  Explain why the advertising to sales ratio for an industry is a more useful gage of advertising intensity than the total dollars spent on advertising.  Explain how price as well as advertising expenditures may be a signal of quality. The student will be able to explain the empirical literature that shows minimal positive correlation between price and quality. Assignments for class 8:  Reading: Pepall, ch. 20, 22; Church, ch. 17-18

Office hours for individual consultations: 

Igor Baranov, on Tuesdays and Thursdays at 4.30 PM or by appointment, office 227 (A. Schultz Building)

Calendar plan of current and final evaluation Class assignment Announcement of coursework results Pre-exam consultation: Exam: Announcement of exam results:

October 1, 2.45 pm, room 408 October 8, 2.30 pm, room 408 October 13, 4:30 pm, room 408 October 15, 1 pm, room 408 October 17, 4:30 pm, room 408

Evaluation system   

Form of current evaluation: class assignments Form of final evaluation: written exam Grading policy: final exam – 70%, class assignment – 30%.

Requited textbooks The following two textbooks can be used interchangeably: Pepall L., D. Richards, G. Norman. Industrial Organization: Contemporary Theory and Empirical Applications. 4th ed. Blackwell Publishing. 2008. (available at GSOM library) Church J., R. Ware. Industrial Organization: A Strategic Approach. McGraw-Hill. 2000. (available online at http://homepages.ucalgary.ca/~jrchurch/ )

Other required reading Besanko D., D. Dranove, M. Shanley, S. Schaefer. Economics of Strategy. 4th ed. John Wiley & Sons. 2007. (The book is used mostly to demonstrate strategic management applications of IO) Porter M. The Five Competitive Forces that Shape Strategy. Harvard Business Review, January 2008.

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