UCB Internet Exercise Worksheet


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Department of Economics
San Francisco State University
Economics 520/820
Internet Exercise 2: Concentration Ratios and Herfindahl–Hirschman Indicies
(Due: Wednesday, April 6)
**You may work with others, but the work you submit must be strictly your own. Copying someone
else’s work will result in a score of zero for all. Your work must be typed, double-spaced with standard
one-inch margins and twelve point font and uploaded within the Internet Exercise 2 assignment portal
on iLearn**
Two measures of the degree of industrial concentration are the concentration ratio and the Herfindahl–
Hirschman Index (HHI). The concentration ratio (CR “N”) tells us the market share of the leading N firms
in an industry. The CR4, therefore, measures the combined market share of the leading 4 firms in an
industry; that is, a CR4 of 20 would imply that the top 4 firms have a combined 20 percent market share.
The HHI is formed by summing the squared market shares of all (or most) firms in an industry. Higher
concentration ratios and HHIs are typically representative of an increasing degree of market concentration
and imperfect competition. The Census Bureau publishes concentration ratios and HHIs for industries as
categorized by the North American Industry Classification System (NAICS). The economic census is
conducted every five years; in this assignment, you will look at data from the 2012 census, as data from the
2017 census is not yet fully released. Go to the Census Bureau at:
In the search field, enter: Concentration Ratios. Click on the table, “Manufacturing: Subject Series:
Concentration Ratios: Share of Value of Shipments Accounted for by the 4, 8, 20 and 50 Largest
Companies for Industries 2012.” At the top of the table, click on the “123 Codes” tab and select “Industry
Codes” then select “All Available NAICS.” Then click X to close menu to view the table. Among other
things, this table presemts concentration ratios and HHIs. The concentration ratios are found in the secondto-last column “Percent of Total Value of Shipments”. The column “Meaning of Firm Concentration
Code” defines the “N” in the CRN given in that row. The HHIs are found in the last column. The second
column of the table gives the corresponding NAICS codes for the industries. Note that since this data is
from the Census of Manufacturers, the table only includes industries with a two-digit NAICS prefix
between 31 and 33 (the sectoral prefixes for manufacturing). See below (Page 2) for tips on navigating
the table.*
1. Navigate through the pages of the table and find three six-digit NAICS industries of interest, each one
beginning with a different two digit prefix: i.e. one that begins 31, one that begins with 32 and one that
begins with 33. For each of these three six-digit industries you have selected, list the corresponding three
through five digit NAICS codes (and industry names) that precede and generate the six-digit industries that
you have chosen (e.g., 339112 Surgical and Medical Instruments Manufactuting – codes preceeding:
339 Miscellaneous Manufacturing; 3391 Medical Equipment and Supplies Manufactuing; 33911 Medical
Equipment and Supplies Manufactuing).
2. For each of the following ranges, 1) CR4 < 15 2) 25 < CR4 < 40 3) 60 < CR4 < 80 4) CR4 > 80
find and list two industries (at either the five or six digit NAICS level) that have CR4’s within the given
range. For each, make sure you list the (five or six digit) NAICS code (do not include any preceeding
digit codes), the industry name, and the value of its CR4. (Note that in this and the next question, your
search may be facillitated by using appropriate filter options from the filter tab).
3. For each of the following ranges, 1) HHI < 1000 2) 1000 < HHI < 1800 3) HHI ? 1800 find and list two industries (at either the five or six digit NAICS level) that have HHI's within the given range (select different industries than you selected for question 2). For each, make sure you list the (five or six digit) industry NAICS code (do not include any preceeding digit codes), the industry name, and the value of its HHI. 4. Question 4 is on Page 2. 4. For each of the (six total) industries you found in question 3, compute the value of the numbers equivalent, using each industry's specific value of the HHI (the numbers equivalent is discussed in lecture video, and it is also in the text). *Tips for navigating the table: you can eliminate some of the columns not needed by clicking on the Columns tab on the far right of table and just keep the following: 2012 NAICS code, Meaning of 2012 NAICS code, Meaning of Firm Concentration Code, Percent of total value of shipments (i.e., the CRN) and Percent of Value of Shipments by the HHI...(the HHI). You can also quickly skip through pages using arrows in the lower right. Industrial Organization THE PEARSON SERIES IN ECONOMICS Abel/Bernanke/Croushore Macroeconomics* Bade/Parkin Foundations of Economics* Berck/Helfand The Economics of the Environment Bierman/Fernandez Game Theory with Economic Applications Blanchard Macroeconomics* Blau/Ferber/Winkler The Economics of Women, Men and Work Boardman/Greenberg/Vining/Weimer Cost-Benefit Analysis Boyer Principles of Transportation Economics Branson Macroeconomic Theory and Policy Brock/Adams The Structure of American Industry Bruce Public Finance and the American Economy Carlton/Perloff Modern Industrial Organization Case/Fair/Oster Principles of Economics* Caves/Frankel/Jones World Trade and Payments: An Introduction Chapman Environmental Economics: Theory, Application, and Policy Cooter/Ulen Law & Economics Downs An Economic Theory of Democracy Ehrenberg/Smith Modern Labor Economics Ekelund/Ressler/Tollison Economics* Farnham Economics for Managers Folland/Goodman/Stano The Economics of Health and Health Care Fort Sports Economics Froyen Macroeconomics Fusfeld The Age of the Economist Gerber International Economics* Gordon Macroeconomics* Greene Econometric Analysis Gregory Essentials of Economics Gregory/Stuart Russian and Soviet Economic Performance and Structure * Hartwick/Olewiler The Economics of Natural Resource Use Heilbroner/Milberg The Making of the Economic Society Heyne/Boettke/Prychitko The Economic Way of Thinking Hoffman/Averett Women and the Economy: Family, Work, and Pay Holt Markets, Games and Strategic Behavior Hubbard/O’Brien Economics* Money, Banking, and the Financial System* Hubbard/O’Brien/Rafferty Macroeconomics* Hughes/Cain American Economic History Husted/Melvin International Economics Jehle/Reny Advanced Microeconomic Theory Johnson-Lans A Health Economics Primer Keat/Young Managerial Economics Klein Mathematical Methods for Economics Krugman/Obstfeld/Melitz International Economics: Theory & Policy* Laidler The Demand for Money Leeds/von Allmen The Economics of Sports Leeds/von Allmen/Schiming Economics* Lipsey/Ragan/Storer Economics* Lynn Economic Development: Theory and Practice for a Divided World Miller Economics Today* Understanding Modern Economics Miller/Benjamin The Economics of Macro Issues Miller/Benjamin/North The Economics of Public Issues Mills/Hamilton Urban Economics Mishkin The Economics of Money, Banking, and Financial Markets* The Economics of Money, Banking, and Financial Markets, Business School Edition* Macroeconomics: Policy and Practice* Murray Econometrics: A Modern Introduction Nafziger The Economics of Developing Countries O’Sullivan/Sheffrin/Perez Economics: Principles, Applications and Tools* Parkin Economics* Perloff Microeconomics* Microeconomics: Theory and Applications with Calculus* Perman/Common/McGilvray/Ma Natural Resources and Environmental Economics Phelps Health Economics Pindyck/Rubinfeld Microeconomics* Riddell/Shackelford/Stamos/ Schneider Economics: A Tool for Critically Understanding Society Ritter/Silber/Udell Principles of Money, Banking & Financial Markets* Roberts The Choice: A Fable of Free Trade and Protection Rohlf Introduction to Economic Reasoning Ruffin/Gregory Principles of Economics Sargent Rational Expectations and Inflation Sawyer/Sprinkle International Economics Scherer Industry Structure, Strategy, and Public Policy Schiller The Economics of Poverty and Discrimination Sherman Market Regulation Silberberg Principles of Microeconomics Stock/Watson Introduction to Econometrics Introduction to Econometrics, Brief Edition Studenmund Using Econometrics: A Practical Guide Tietenberg/Lewis Environmental and Natural Resource Economics Environmental Economics and Policy Todaro/Smith Economic Development Waldman Microeconomics Waldman/Jensen Industrial Organization: Theory and Practice Weil Economic Growth Williamson Macroeconomics Log onto www.myeconlab.com to learn more. Industrial Organization THEORY AND PRACTICE FOURTH EDITION Don E. Waldman Colgate University Elizabeth J. Jensen Hamilton College Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam CapeTown Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City Sa~o Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo To our families, Lynn, Abigail, Laura, and Gregory Bob, Ben, and Annie Editorial Director: Sally Yagan Editor in Chief: Donna Battista Senior Acquisitions Editor: Adrienne D’Ambrosio Editorial Assistant: Elissa Senra-Sargent Editorial Project Manager: Jill Kolongowski Senior Managing Editor: Nancy H. 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Microsoft and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all warranties and conditions of merchantability, whether express, implied or statutory, fitness for a particular purpose, title and non-infringement. In no event shall Microsoft and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from the services. The documents and related graphics contained herein could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Microsoft and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time. Partial screen shots may be viewed in full within the software version specified. Microsoft® and Windows® are registered trademarks of the Microsoft Corporation in the U.S.A. and other countries. This book is not sponsored or endorsed by or affiliated with the Microsoft Corporation. Copyright © 2013, 2007 by Pearson Education, Inc. All rights reserved. Manufactured in the United States of America. This publication is protected by Copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this work, please submit a written request to Pearson Education, Inc., Permissions Department, One Lake Street, Upper Saddle River, New Jersey 07458, or you may fax your request to 201-236-3290. Many of the designations by manufacturers and sellers to distinguish their products are claimed as trademarks. Where those designations appear in this book, and the publisher was aware of a trademark claim, the designations have been printed in initial caps or all caps. Library of Congress Cataloging-in-Publication data Waldman, Don E. Industrial organization : theory and practice[03] / Don E. Waldman, Elizabeth J. Jensen.—4th ed. p. cm.—(The Pearson series in economics) ISBN-13: 978-0-13-277098-9 ISBN-10: 0-13-277098-9 1. Industrial organization (Economic theory) 2. Industrial organization. 3. Industrial policy. I. Jensen, Elizabeth Jane. II. Title. HD2326.W349 2013 338.9—dc23 2011042924 10 9 8 7 6 5 4 3 2 1 ISBN 10: 0-13-277098-9 ISBN 13: 978-0-13-277098-9 ABOUT THE AUTHORS DON E. WALDMAN is the Richard M. Kessler Professor of Economic Studies at Colgate University. He has taught at Colgate since 1981 and has served as chair of the economics department and director of the division of social sciences. Before arriving at Colgate, he received outstanding teaching awards at Cornell University and the University of Maryland, Baltimore County. Professor Waldman received a B.A. in mathematics from Temple University, an M.A. in economics from Brown University, and a Ph.D. in economics from Cornell University. He is the author of three other books, Microeconomics, Antitrust Action and Market Structure, and The Economics of Antitrust: Cases and Analysis, as well as numerous articles, comments, and book reviews. Professor Waldman has also served as a consultant and expert witness on legal cases, specializing in antitrust, for both the government and private firms. In addition to teaching a wide variety of courses at Colgate, on three occasions Professor Waldman has led a group of honors students to study economics for a semester in London. He has been teaching courses on industrial organization and public policy for more than 30 years. Professor Waldman lives in Hamilton, New York, with his wife. They have two children. ELIZABETH J. JENSEN is Professor of Economics at Hamilton College. She has taught at Hamilton since 1983 and has served as chair of the economics department. She has been honored twice for her teaching, most recently being named the Christian A. Johnson Excellence in Teaching Professor for 2011 through 2014. Professor Jensen received a B.A. in economics from Swarthmore College and a Ph.D. in economics from the Massachusetts Institute of Technology. Before coming to Hamilton, she worked at the Council of Economic Advisers. She has recently been investigating the predictors of academic success in college. Professor Jensen, who fondly remembers her first course in industrial organization at Swarthmore College as being the course that made her decide to become an economist, has been teaching courses on industrial organization since she came to Hamilton College. She lives in Clinton, New York, with her husband. They have two children. v This page intentionally left blank BRIEF CONTENTS PART I THE BASICS OF INDUSTRIAL ORGANIZATION CHAPTER 1 Introduction 1 CHAPTER 2 The Firm and Its Costs 16 CHAPTER 3 Competition and Monopoly 50 CHAPTER 4 Market Structure 87 CHAPTER 5 Monopoly Practices 138 CHAPTER 6 Empirical Industrial Organization 160 PART II MODERN INDUSTRIAL ORGANIZATION: GAME THEORY AND STRATEGIC BEHAVIOR CHAPTER 7 Game Theory: A Framework for Understanding Oligopolistic Behavior 201 CHAPTER 8 The Development of Theory 225 CHAPTER 9 Collusion: The Great Prisoner’s Dilemma 259 CHAPTER 10 Cartels in Action 307 CHAPTER 11 Oligopoly Behavior: Entry and Pricing Strategies to Deter Entry 339 CHAPTER 12 Oligopoly Behavior: Entry and Nonpricing Strategies to Deter Entry 375 PART III BUSINESS PRACTICES CHAPTER 13 Product Differentiation 418 Advertising 455 CHAPTER 15 Technological Change and Research and Development CHAPTER 16 Price Discrimination 532 CHAPTER 17 Vertical Integration and Vertical Relationships 582 CHAPTER 18 Regulation and Deregulation 628 CHAPTER 14 486 Glossary 659 Answers to Odd-Numbered Problems 668 Index 697 Credits 731 vii This page intentionally left blank CONTENTS P REFACE xxi PART I CHAPTER THE BASICS OF INDUSTRIAL ORGANIZATION 1 Introduction 1 1.1 Two Approaches to the Study of Industrial Organization 3 1.1.1 The Structure-Conduct-Performance (SCP) Approach 1.1.2 The Chicago School Approach 6 3 1.2 Static Versus Dynamic Models 7 1.3 Theory and Empiricism 7 1.4 Government and Industrial Organization 8 1.4.1 The Content of the Antitrust Laws 1.4.2 Enforcement Procedures 11 8 1.5 The Global Economy and Industrial Organization 12 1.6 General Approach of This Book 13 SUMMARY CHAPTER 2 13 The Firm and Its Costs 16 2.1 The Neoclassical Firm 16 2.2 The Theory of the Firm 17 2.2.1 A Firm’s Boundaries 17 APPLICATION 2.1 A Chip of Its Own 2.3 The Structure of Modern Firms 20 21 2.3.1 Separation of Ownership and Control 2.3.2 Managerial Objectives 22 22 APPLICATION 2.2 Executive Compensation: Pay for Performance? 23 APPLICATION 2.3 X-Inefficiency Goes Extreme: Putting Masseuses, Christmas Trees, Renoirs, and Monets on the Company Payroll 2.3.3 Feasibility of Profit Maximization 25 24 APPLICATION 2.4 How Do Firms Use Rule-of-Thumb Pricing? 2.3.4 Constraints on Managers 28 26 APPLICATION 2.5 Stockholder Revolt at the Happiest Place on Earth: The Disney Stockholders Versus Michael Eisner 28 ix x CONTENTS 2.4 The Profit-Maximizing Output Level 31 2.5 Cost Concepts: Single-Product Firms 31 2.5.1 Accounting Costs Versus Economic Costs 2.5.2 Short-Run Costs of Production 32 31 APPLICATION 2.6 When Do Sunk Costs Matter to a Firm? 33 2.5.3 Long-Run Costs of Production and Economies of Scale APPLICATION 2.7 A Measure of Economies of Scale 2.6 Cost Concepts: Multiproduct Firms 37 39 41 APPLICATION 2.8 A Measure of Economies of Scope 42 APPLICATION 2.9 Are There Economies of Scope in Institutions of Higher Education? 43 SUMMARY CHAPTER 3 44 Competition and Monopoly 50 3.1 The Economics of Perfect Competition 50 3.1.1 The Assumptions of Perfect Competition 3.1.2 The Firm’s Supply Curve 53 51 APPLICATION 3.1 Short-Run Losses in the Airline Industry 55 3.1.3 The Market Supply Curve and Equilibrium 56 3.1.4 Properties of Competitive Equilibrium 57 3.2 Introduction to Welfare Economics 58 APPLICATION 3.2 Consumer and Producer Surplus and the Basic Theory of the Gains from Trade 58 3.3 The Economics of Monopoly 61 3.3.1 The Relationship Between Marginal Revenue and Price 61 3.3.2 Elasticities, the Degree of Market Power, and the Lerner Index 63 3.4 Welfare Comparison 65 3.4.1 Measurement of the Costs of Market Power 66 APPLICATION 3.3 Monopoly Rent-Seeking in the Pharmaceutical Industry 3.4.2 Cautions 68 3.5 Present Value and Discounting 70 3.6 Antitrust Policy Toward Monopolization 3.6.1 Early Cases 72 72 APPLICATION 3.4 American Tobacco’s “Attempt to Monopolize” 3.6.2 The Alcoa Era 74 3.6.3 More Recent Trends in Section 2 Cases 76 3.6.4 Section 2 in the Twenty-First Century 79 SUMMARY 80 73 67 CONTENTS CHAPTER 4 Market Structure xi 87 4.1 Concentration in Individual Markets 88 4.1.1 Structure-Based Measures 88 APPLICATION 4.1 Aggregate Concentration Within the United States and Globally 89 4.1.2 Definition of the Relevant Market 4.2 Entry and Exit 93 95 4.2.1 Patterns of Entry and Exit 95 4.2.2 Entry 96 4.2.3 Static or Structural Barriers to Entry 97 APPLICATION 4.2 How Do Economists Estimate Economies of Scale? 99 APPLICATION 4.3 What Does the Evidence Say About Barriers to Entry? 4.2.4 Incentives to Enter 109 4.2.5 Exit 110 4.2.6 The Interaction of Entry and Exit 4.3 Mergers 108 111 112 4.3.1 Merger History 113 4.3.2 Motives for Merger 115 APPLICATION 4.4 What’s Brewing in the Beer Industry? 118 4.3.3 The Effects of Horizontal Mergers on Competition and Welfare 119 4.3.4 Empirical Evidence on the Effects of Mergers 122 4.3.5 Public Policy Toward Horizontal Mergers 123 4.3.6 Merger Guidelines and the Hart-Scott-Rodino Act 127 SUMMARY CHAPTER 5 130 Monopoly Practices 5.1 Dominant-Firm Price Leadership Model 138 138 5.1.1 Sources of Dominance 139 5.1.2 Pricing by a Dominant Firm 139 APPLICATION 5.1 Banks and Credit Unions: Dominant Firms and Fringe Suppliers? 144 5.1.3 Empirical Evidence of the Decline of Dominant-Firm Price Leaders 144 5.2 Contestable Markets: A Check on Market Power? 5.3 Network Economics 148 145 5.3.1 Complementarity, Compatibility, and Standards 5.3.2 Externalities 150 149 xii CONTENTS 5.3.3 Switching Costs and Lock-In 151 5.3.4 Significant Economies of Scale 151 5.3.5 Math of Network Externalities 151 5.3.6 Summary of Network Effects 154 APPLICATION 5.2 Microsoft and Network Effects SUMMARY CHAPTER 6 154 155 Empirical Industrial Organization 160 6.1 Structure-Conduct-Performance 160 6.2 Statistical Tools Used to Test the SCP Paradigm 161 6.2.1 Exogenous and Endogenous Variables 166 6.3 Measurement Issues 166 6.3.1 Measures of Performance 166 6.3.2 Summary of Measures of Profitability 6.4 Measures of Market Structure 168 169 6.4.1 Measures of Concentration 6.4.2 Barriers to Entry 169 6.4.3 Other Variables 170 169 6.5 Early Structure-Conduct-Performance Studies 6.6 Econometric Studies 171 170 6.6.1 Concentration and Profitability: Evidence from Industry-Level Studies 172 6.6.2 Summary of Industry-Level Results 173 6.7 Conceptual Problems with SCP Studies 173 6.7.1 Collusion Versus Efficiency 173 6.7.2 Assumption of Linearity 175 6.7.3 Variations over Time 176 6.7.4 Endogeneity Problem 177 6.8 Prices and Concentration 178 6.9 An Alternative Approach: Sunk Costs and Market Concentration 179 6.9.1 Markets with Exogenous Sunk Costs 180 6.9.2 Markets with Endogenous Sunk Costs 180 6.9.3 Sutton’s Empirical Tests 181 APPLICATION 6.1 Applying Sutton’s Theory in the Supermarket Industry 182 6.10 The New Empirical Industrial Organization 184 6.10.1 Structural Models that Estimate the Demand Curve and the Supply Relationship in a Market 185 6.10.2 Additional Approaches to the New Empirical Industrial Organization 191 CONTENTS xiii 6.10.3 Summary of New Empirical Industrial Organization Evidence 192 APPLICATION 6.2 Price–Cost Margins in the RTE Cereal Industry SUMMARY PART II CHAPTER 7 193 194 MODERN INDUSTRIAL ORGANIZATION: GAME THEORY AND STRATEGIC BEHAVIOR Game Theory: A Framework for Understanding Oligopolistic Behavior 7.1 What Is Game Theory? 201 201 7.1.1 The Information Structure of Games 7.2 Simple Zero-Sum Games 202 203 APPLICATION 7.1 University Rankings and Merit-Based Financial Aid as a Zero-Sum Game 205 7.3 Prisoner’s Dilemma Games 206 APPLICATION 7.2 A Prisoner’s Dilemma—Doctors and HMOs 7.4 Repeated Games 209 7.5 Games of Mixed Strategies 7.6 Sequential Games 213 208 210 7.6.1 Credible Versus Noncredible Threats and Subgame Perfect Nash Equilibria 215 APPLICATION 7.3 Dr. Strangelove and Credible Threats Gone Wrong SUMMARY CHAPTER 8 216 217 The Development of Theory 225 8.1 Models Based on Quantity Determination 225 8.1.1 The Cournot Model 225 8.1.2 The Cournot–Nash Equilibrium 230 8.1.3 Cournot–Nash Model with More Than Two Firms 8.1.4 Examples of Cournot–Nash Pricing in Real Markets 235 234 APPLICATION 8.1 Empirical Evidence of Cournot–Nash Behavior—Experimental Games with Varying Numbers of Players 238 APPLICATION 8.2 The Paradox of Mergers in a Cournot–Nash Market 240 xiv CONTENTS 8.2 The Stackelberg Model 240 8.2.1 Firms with Identical Costs and Demand 241 8.2.2 The Stackelberg Model: Firms with Different Costs 243 APPLICATION 8.3 Empirical Examples of Stackelberg Equilibrium 245 8.3 The Bertrand Model 247 APPLICATION 8.4 Brazil and Columbia in the Coffee Export Market 250 APPLICATION 8.5 Bounded Rationality, Sluggish Consumers, Internet Pricing, and the Failure to Achieve Bertrand Equilibrium 251 8.3.1 The Bertrand–Edgeworth Model with Capacity Constraints 252 SUMMARY CHAPTER 9 255 Collusion: The Great Prisoner’s Dilemma 9.1 The Prisoner’s Dilemma Revisited 259 259 APPLICATION 9.1 Tit-for-Tat in Baseball 261 APPLICATION 9.2 A Real-World Example of “Nice” Behavior in Response to Random or “Accidental” Defections Automobiles 266 9.2 Another Strategy for Maintaining Effective Collusion: Trigger Price Strategies 267 9.2.1 Trigger Prices in Games with Uncertainty 268 9.2.2 Trigger Prices in Games with Uncertain Demand 272 9.2.3 Trigger Prices with Observable Random Changes in Demand 274 APPLICATION 9.3 The United Kingdom Salt Duopoly 276 9.3 Collusive Agreements as Viewed by One Firm in a Cartel 278 9.4 Factors Affecting the Ease or Difficulty of Effective Collusion 285 9.4.1 The Existence of Market Power 285 9.4.2 The Costs of Reaching and Maintaining an Agreement 286 APPLICATION 9.4 Factors Facilitating Global Cartels: Evidence from Lysine, Citric Acid, and Vitamins A and E 9.5 Antitrust Policy Toward Collusion 289 291 9.5.1 Public Policy Toward Direct Price-Fixing Agreements 293 9.5.2 Price-Exchange Agreements 294 9.5.3 Oligopolistic Behavior—Conscious Parallelism 295 9.5.4 Trade Associations 297 9.5.5 Nonprofit Organizations: Cases Involving Colleges and Universities 298 SUMMARY 300 xv CONTENTS CHAPTER 10 Cartels in Action 307 10.1 Attempted Methods of Achieving Effective Collusion 307 10.1.1 Dominant-Firm Price Leader and Benefactor 10.1.2 Price Leadership 310 307 APPLICATION 10.1 A Sweet Case of Price Leadership: Dole and Del Monte in the Canned Pineapple Industry 315 10.1.3 Most Favored Customer Clauses and “Low-Price” Guarantees 316 APPLICATION 10.2 Most Favored Customer Clauses for Medicaid, But What About Everyone Else? 318 10.1.4 Basing Point Pricing Systems 319 10.1.5 Trade and Professional Associations 321 APPLICATION 10.3 “Something Is Rotten in the State of Denmark”: The Danish Government Promotes Tacit Price Fixing 323 10.1.6 Schemes to Divide Markets 325 10.1.7 Patent Cartels 327 10.2 How Successful Are the Solutions? 329 10.2.1 Excess Capacity Problems 329 10.2.2 Encroachment of Substitute Products 330 10.2.3 More Effective Antitrust Strategies: The Department of Justice Corporate Leniency Program 330 SUMMARY CHAPTER 11 333 Oligopoly Behavior: Entry and Pricing Strategies to Deter Entry 11.1 Limit Pricing 339 339 11.1.1 Limit Pricing with a Cost Advantage for the Monopolist Firm 11.1.2 Limit Pricing in the Absence of a Cost Advantage for the Monopolist Firm 342 11.1.3 The Critique of Game Theorists 343 11.1.4 Limit Pricing with Asymmetric Information 348 11.1.5 Empirical Evidence of Limit Pricing 351 APPLICATION 11.1 Limit Pricing in the Antihistamine Market 11.2 Predatory Pricing 339 354 355 11.2.1 Predatory Pricing with Perfect, Certain, Complete, and Symmetric Information 356 11.2.2 Predatory Pricing with Imperfect, Certain, Incomplete, and Asymmetric Information 357 11.2.3 The Kreps and Wilson Predatory Pricing Game 358 11.2.4 Empirical Evidence: Predatory Pricing and Building a Tough Reputation 359 xvi CONTENTS APPLICATION 11.2 Does Wal-Mart Use Predatory Pricing? 361 APPLICATION 11.3 Don’t Mess with Bill: Netscape Versus Microsoft in the Internet Browser Market SUMMARY 363 365 APPENDIX: DETAILS OF THE KREPS AND WILSON PREDATORY PRICING MODEL CHAPTER 12 370 Oligopoly Behavior: Entry and Nonpricing Strategies to Deter Entry 12.1 Excess Capacity 375 375 12.1.1 Investing in Research and Development to Lower Costs 12.1.2 Empirical Evidence 379 12.2 Raising Rivals’ Costs 379 381 12.2.1 Lobbying to Increase Barriers to Entry 383 12.2.2 Increasing Advertising 383 12.2.3 Providing Complementary Goods and Services 384 12.2.4 Sabotaging Corporate Competitors 384 12.2.5 Empirical Evidence on Raising Rivals’ Costs 384 APPLICATION 12.1 Detergent Wars and the Battle of Good Versus Evil: Amway v. Procter & Gamble 387 12.3 Learning by Doing 389 12.3.1 Empirical Evidence on Learning by Doing 390 APPLICATION 12.2 Qualitative Learning by Doing in the Motion Picture Industry: The Case of the “Talkies” 12.4 Product Proliferation 394 395 12.4.1 Empirical Evidence on the Use of Product Proliferation 396 12.5 Empirical Evidence on the Use of Price and Nonprice Strategies to Deter Entry 401 SUMMARY 403 APPENDIX: PRODUCT PROLIFERATION REVISITED PART III CHAPTER 13 410 BUSINESS PRACTICES Product Differentiation 13.1 Forms of Product Differentiation 418 13.2 Theoretical Analysis of Product Differentiation 418 419 13.2.1 Product Differentiation in Spatial Models 420 xvii CONTENTS 13.3 The Bertrand Model with Product Differentiation 428 13.4 The Economics of Monopolistic Competition and the Optimal Amount of Variety 430 13.4.1 The Welfare Benefits of Variety with Monopolistic Competition 432 APPLICATION 13.1 “It’s Not Delivery. It’s DiGiorno”: Monopolistic Competition in the Frozen Pizza Market 436 13.5 Product Differentiation with Asymmetric Information 437 13.5.1 The Lemons Model 437 13.5.2 Adverse Selection 440 13.5.3 Dealing with the Problems Associated with Product Differentiation, Asymmetric Information, and Adverse Selection 441 APPLICATION 13.2 What Do the Markets for Thoroughbred Racehorses and Baseball Players Have in Common? Product Differentiation, Asymmetric Information, and Adverse Selection 442 APPLICATION 13.3 Adverse Selection in Internet Dating, or So, If He’s/She’s So Great, Why Is He/She Using eHarmony to Get a Date? 444 13.6 The Product Differentiation Advantages of First Movers SUMMARY CHAPTER 14 445 450 Advertising 455 14.1 The Social Benefits of Advertising 455 14.2 The Social Costs of Advertising 457 14.2.1 Advertising and Quality 459 14.3 Advertising and Market Structure 462 14.3.1 Welfare Effects of Advertising 462 14.3.2 The Dorfman–Steiner Model 464 14.3.3 Advertising and Oligopoly Behavior 466 APPLICATION 14.1 The Variability of the Advertising-to-Sales Ratios Across Industries 470 14.4 Advertising as a Barrier to Entry 473 14.5 Strategic Advantages of Heavily Advertised Brands 475 14.6 Product Differentiation and Increased Competition 475 14.7 Empirical Evidence 476 14.7.1 Traditional Studies of the Relationship between Advertising and Performance Across Industries 476 14.7.2 New Empirical Industrial Organization Studies 479 SUMMARY 481 xviii CHAPTER CONTENTS 15 Technological Change and Research and Development 15.1 Schumpeter and the Process of “Creative Destruction” APPLICATION 15.1 Examples of Creative Destruction 486 486 488 15.2 The Process of Technological Change 488 15.3 The Relationship Between Market Structure, Firm Size, and Technological Advance 489 15.3.1 The Impact of Oligopoly 491 15.3.2 Dominant Firms as Fast-Second Innovators 496 15.3.3 A Contribution of Game Theory 498 15.3.4 The Theoretical Impact of a Patent System 500 15.4 The Impact of Firm Size 503 15.5 Empirical Evidence 505 15.5.1 Measurement Issues 505 15.5.2 Testing Schumpeter’s Hypotheses 15.6 The Economics of the Patent System 507 512 15.6.1 Empirical Evidence on the Impact of Patents 515 15.6.2 Intellectual Property Rights and Copyrights 518 APPLICATION 15.2 Why Bother with Intellectual Property Rights? The Case of China 518 15.7 Patents, Intellectual Property Rights, and the Law SUMMARY 522 APPENDIX: GAME THEORY AND PATENT RACES CHAPTER 16 520 529 Price Discrimination 16.1 Types of Price Discrimination 532 532 16.1.1 First-Degree Price Discrimination 533 APPLICATION 16.1 Microsoft’s Attempt to Use First-Degree Price Discrimination 534 16.1.2 Second-Degree Price Discrimination 535 APPLICATION 16.2 The Use of Coupons and Second-Degree Price Discrimination 537 16.1.3 The Welfare Effects of Second-Degree Price Discrimination 539 16.1.4 Third-Degree Price Discrimination 540 16.1.5 Welfare Implications of Third-Degree Price Discrimination 540 APPLICATION 16.3 Third-Degree Price Discrimination at Disney World APPLICATION 16.4 Combining Second-Degree and Third-Degree Price Discrimination in Broadway Theater Tickets 16.2 Two-Part Tariffs, Tying, and Bundling 545 547 544 xix CONTENTS 16.2.1 Two-Part Tariffs 547 16.2.2 The Welfare Effects of a Two-Part Tariff 549 APPLICATION 16.5 Changing Pricing Strategies at Disneyland and Disney World 551 16.2.3 Bundling 551 16.2.4 Mixed Bundling 552 APPLICATION 16.6 Mixed Bundling in Over-the-Counter Cold Remedies 16.2.5 Requirements Tie-in Sales 558 16.3 Distribution Effects of Price Discrimination 559 16.4 Effect on Competition 560 16.5 Antitrust: Price Discrimination and the Robinson–Patman Act 16.5.1 Secondary-Line Cases 563 16.5.2 Primary-Line Cases 568 16.5.3