Wednesday, November 25, 1998

The University of Texas at Austin

Department of Economics

Industrial Organization EC 328

Professor R. Preston McAfee

ECB 3.102D

(512) 475-8533

mcafee@eco.utexas.edu

Office Hours: T,Th 2:30-3:30

TA: TBA

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Table of Contents

General Information
Text
Related Texts
Assessment
Immutable Deadlines
Mathematics Requirement
Presentation
Class Assessment
Choose a Paper Topic
Paper Writing Strategy
1. Collect Information
2. Draw a Conclusion
3. Organize your facts
4. Write
Criteria for Evaluating the Paper
1. Clarity
2. Organization
3. Argument and Evidence
4. Documentation
5. Quality of Writing
6. Insight and Interest
Class Topics
1. What is Industrial Organization?
2. Organization of the Firm.
3. Monopoly and Price Discrimination
4. Strategic Behavior in Oligopoly
5. Merger Analysis and Antitrust
6. Price Dispersion
7. Conspiracy, Cartels and Tacit Collusion
8. Advertising
9. Entry and Exit
10. Product Differentiation and Patents
11. Auctions and Bidding
12. Agency Theory
13. Insurance
14. Bilateral Bargaining and The Market for Lemons

 

Text:

Pepall, Lynne, Daniel Richards and George Norman, "Industrial Organization: Contemporary Theory and Practice," Southwestern College Publishing, 1999.

Related Texts

Carlton, Dennis, and Jeffrey Perloff, Modern Industrial Organization, Glenview, IL: Scott Foresman, 1989.

Tirole, Jean, The Theory of Industrial Organization, Cambridge: MIT Press, 1988.

Posner, R. and F. Easterbrook, Antitrust Cases, Economic Notes and Other Materials, Second Edition, St. Paul, MN: West, 1981.

Scherer, F.M. Industrial Market Structure and Economic Performance, Third Edition, Boston: Houghton Mifflin, 1990.

Schmalensee, Richard, and Robert Willig, (eds), Handbook of Industrial Organization, Amsterdam: North-Holland, 1989.

Assessment

This is a substantial writing component course. You will choose a topic early in the course and prepare a 15-20 page paper on this topic. A draft must be finished by the date listed below. The T.A. and professor will provide comments, criticisms and suggestions for further work, and you will prepare a substantially-revised final version of your paper.

Each student will present their paper, with a fifteen minute presentation, during the final weeks of class. In addition, there will be discussion of other students' papers. Assessment will be based on the quality of the paper, the quality of the presentation, discussion of other students' papers, and class participation. A take-home exam will account for approximately 20% of the grade.

Immutable Deadlines

Because of the organization of the course, there are three deadlines that must be met, NO EXCEPTIONS. Do not ask for an exception.

Thursday, February 4, 1999: Proposal for your research paper is due. The proposal should list the topic you will study, and some sources of information and references. Two pages is sufficient. The proposal must be typed.

Thursday, March 4, 1999: First draft of your paper is due. This should be a complete, typed paper, well-organized, and with full references. That is, it should be at least your third draft--just the first draft to be handed in. You will receive comments within a week.

April 13, 1999: Final paper is due. Presentations start on April 20, 1999. The papers will be xeroxed and available as a packet with a nominal charge. You are expected to read every paper.

Mathematics Requirement

Calculus is required for this course. The mathematics of industrial organization is called game theory, and is not arduous. Some game theory will be introduced in class. You are not expected to have studied game theory before.

Presentation

Each student will present their paper in class. There are two ways to present. First, we will use the last three weeks of class for 18 presentations. In addition, we will schedule an evening (6:30PM-9PM) for presentations. Students with conflicts will not be penalized.

Twenty-five minutes is devoted to presentations. Each presentation will take no more than fifteen minutes. The assigned discussant takes no more than five minutes, and the random discussant will take a minute, so that there is some time for class participation on each topic.

You will be assigned to discuss a paper, and you will know which paper well in advance. You are expected to prepare serious comments on that paper. In addition, after each presentation, a discussant will be picked at random. You are expected to have a remark or two to make about each paper. You will find most of the papers quite interesting.

Class Assessment

I will ask you identify the best papers and the worst papers, and why (exempting yourself). Your remarks will be kept strictly confidential. Similarly, I will ask you to rate the presentations.

Choose a Paper Topic

You should choose a topic immediately. We are on a very tight time schedule with no room for slippage.

All papers must be industrial organization papers. This means they have to be about firms. But there is a great deal of flexibility in the choice of topic.

Most students in the past have chosen to study a particular industry. For this type of paper, you pick an industry like automobiles, airlines, football, romance novels, dating services, banana production, or pre-stressed concrete, and study that industry. The study begins with identifying the firms in the industry, then identifying and evaluating the competition strategies used by the firms (pricing, research and development, advertising, creation of brand-names, mergers, in-house vs. subcontracted production).

A second approach is to choose a story about the behavior of a firm from a newspaper or other source, and research this story. For example, the defense contractor Lockheed-Martin announced a friendly takeover of Northrop-Grumman, and then later dropped the plan after the Department of Justice filed an antitrust complaint. This story contains a dozen potential paper topics. How is the defense industry organized? Why did they want to merge? Why did the DOJ want to block the merger? How does the antitrust division of the DOJ work?

A third approach is to thumb through the text and the reference books and pick a topic that seems interesting to you, and survey the literature on the topic. An advantage of this approach is that you start with a reference. You are not limited to the course topics.

I strongly encourage you to choose a topic in which you are interested rather than one that looks easy. Topics that look easy can be treacherous and unpleasant if they are boring.

Papers from previous years are available in two hour checkout at the library. Only papers which received an "A" are shown.

Paper Writing Strategy

1. Collect Information

Once you have chosen a topic, you should go out and collect a lot of information. An obvious starting place is the web. Much of the information on the web, unfortunately, is unreliable; I would like you to attempt to verify anything you find there. There is a service available at the library called EconLit which will identify economics papers by topic. Many of the articles you find this way will be difficult to read due to their mathematical content.

The Journal of Economic Perspectives and Journal of Economic Literature generally do not have a great deal of mathematics. In addition, papers in the American Economic Review and the Journal of Political Economy tend to have extensive, readable introductions. Industrial organization journals include Rand Journal of Economics, Journal of Industrial Economics, International Journal of Industrial Organization, and Journal of Economics and Management Strategy. Unfortunately, IO journals tend to be very technical. Occasionally good, readable IO papers may be found in Economic Inquiry.

For any given industry, there are usually several books that describe the industry. In addition, it is useful to interview people who work in a relevant industry. Prior to interviewing, however, you should carefully think about what you wish to learn and write questions down, to be sure you learn what you need to learn.

Another source of information is J-Stor, which contains 100 years of economics articles, downloadable as Adobe Acrobat files. It is located at

http://www.jstor.org/journals/

2. Draw a Conclusion

This is probably the single hardest part of the job you face. After completing part 1, you are confronted with a huge mass of information. What will you write about?

The best strategy is draw a conclusion--find a point to make in your paper. The main point of your paper is called a thesis. Such points might be:

The banana industry attempts to create brand names as a method of decreasing demand elasticity, with mixed success.

Free agency would destroy professional football.

The Department of Justice should lose its antitrust case against Microsoft.

Dry-cleaners can price discriminate against women because of imperfect information.

The hub-and-spoke airline routing system evolved to minimize transportation costs, but has produced significant market power for airlines.

Finding a thesis in a giant pile of information is often quite difficult. You can adopt some other author's thesis and attempt to support it with additional information. If you disagree with an author's thesis, you can choose the opposite thesis and attempt to prove that. If that doesn't produce a topic on which you wish to write, try putting your notes and materials away, and just write a stream-of-consciousness about what you have learned from your reading. Some of what is written this way will make no sense, but you may find "diamonds in the rough," nuggets of thought-provoking inspiration which will form the core of an argument.

3. Organize your facts

Once you have a thesis, cull through your information to select relevant information. Even in this electronic age, index cards remain a useful way of organizing facts. Some information may be useful as background toward understanding the question, as direct support of the thesis, as indirect support, or as contrary information. Do not throw away contrary information. The object is to be accurate, which means assessing all of the relevant information.

It will occasionally occur that the point you set out to make appears to be false, and that the evidence convinces you of the contrary view. This is fine; it requires revising your thesis, but it also means that you learned something significant.

4. Write

While electronics isn't much of a help to organization of materials, it is a massive help to writing. For most people, the best strategy is to write then repeatedly revise until the material flows smoothly, there are no extraneous asides, and the paper reads clearly. Cooperation also helps--if someone will read your paper and tell you what they found confusing, you know where to focus your efforts at revising. (A trade is a good way to arrange such external reading.)

Don't expect perfect prose, complete with salient quotations and proper grammar, to flow out in paragraph form. Ideas come in pieces and the evidence is scattered throughout your research materials. Get something written and then set about making it better.

Criteria for Evaluating the Paper

The following questions are designed to help you improve your draft.

1. Clarity

  1. Are the thesis and argument stated clearly in the introduction? The introduction should tell the reader what you will accomplish with the paper.
  2. Does the reader know what question you have set out to answer, and how you intend to answer it?
  3. Throughout the paper, are the connections between ideas and evidence made clear?

2. Organization

  1. How does each paragraph relate to and develop the argument?
  2. Do ideas and evidence follow each other in a linear sequence?

3. Argument and Evidence

  1. Is the argument supported by different types of evidence? Have you provided sources?
  2. How does your argument take into account specific arguments by experts on the topic?
  3. How well are counter-arguments addressed? It is important that you include not just the evidence for your argument, but the evidence against it as well.

4. Documentation

  1. Are a variety of sources used?
  2. Are the size and form of quotes appropriate? Remember that quotes are generally used only in two circumstances.
  3. Quotes are used when they express an idea extremely well. Otherwise you should paraphrase the source with a reference.
  4. Quotes are used to be fair to someone whose opinion you oppose.
  5. Are your sources authoritative and scholarly? A high school text, tourist guide or fictional novel will not generally produce the level of scholarship desired.

5. Quality of Writing

  1. Are the style and tone of the paper appropriate?
  2. Are transitions from idea to idea smooth and easy to follow?
  3. Check spelling and grammar.
  4. Does the paper have a logical structure?
  5. The desired structure has the form "introduction, argument, conclusion."
  6. The introduction sets out the issues, provides motivation and background, and provides an overview of the paper.
  7. The middle section, which is the longest and may need to be divided into several sections, makes your point.
  8. The conclusion sums up, and perhaps handles some of the potential criticisms.
  9. When possible, make the paper flow linearly, so that each paragraph starts where the previous paragraph stops.

6. Insight and Interest

  1. Do you show that the subject is worth thinking about? Is the paper properly motivated?
  2. Do your paper keep the reader's interest? (If possible, get a friend to read your paper, and ask the friend to identify parts that are confusing, boring, tedious, or poorly written.)
  3. Does the paper fit into an industrial organization course
  4. Does it use industrial organization theory to help the reader understand the facts?
  5. Does it use facts from an industry to help us understand how firms compete?

 

Class Topics (Not all of the topics will be covered.)

1. What is Industrial Organization?

This is the introductory lecture.

2. Organization of the Firm.

Whether a mix of activities is carried out by one firm, or by several distinct firms (tied by contracts, perhaps) affects the resolution of disputes, the distribution of profits not contracted on (residual claims) and the decision-making if events not contracted on arise.

3. Monopoly and Price Discrimination

After a review of the standard monopoly model, we will consider several topics in price discrimination. Price discrimination may be based on observable characteristics (e.g. mailing coupons to certain addresses) or operate through self-selection (e.g. quantity discounts and newspaper coupons available to all), or both. Spatial price discrimination will be analyzed as well. An issue related to price discrimination, monopoly bundling (Shoe: buy one, get one free) will be analyzed. The welfare impact of price discrimination will be considered. Price discrimination is illegal in the United States, although the law admits many exceptions. The design and regulation of monopolies will be considered in environments where the regulator knows less about the costs of the firms than does the monopoly.

4. Strategic Behavior in Oligopoly

Unlike the competitive or monopoly models, oligopoly models are based on the understanding that firms recognize and react to the effect that their decisions have on other firms. We will start with the simplest models, n firms competing to sell a homogenous good to a large group of consumers. Solutions to the static problem will be developed (under quantity and price competition), and then the use of trigger strategies and meet or beat pricing to support high prices considered.

5. Merger Analysis and Antitrust

Why do firms merge? What are the laws and regulations governing mergers? Only a few of the usual reasons stated for mergers have been formally modelled, but most the reasons are interesting, and some even seem plausible. The laws and regulations governing mergers (and, indeed most economic activity) often seem to have little connection to a sensible economic analysis, although economic analysis is used extensively to come up with these laws and regulations.

6. Price Dispersion

Prices of identical objects may sell for distinct prices at nearby stores, a phenomenon called price dispersion. Simple models of price dispersion and its effects on competition are considered.

 

7. Conspiracy, Cartels and Tacit Collusion

One of the triumphs of game theoretic modelling of firm behavior was understanding how competing firms might profitably not compete with each other, by the use of implicit threats and tacit collusion. This understanding overturned a widely held but erroneous belief that cartels must eventually fail (such claims were made, even about OPEC, which, of course, did in fact fail as a successful cartel). However, the power of the theory, even to operate in environments with limited observability of rival's actions and incomplete ability to punish defectors, left an equally large mystery: why don't cartels always succeed, and why do they occasionally fall apart?

In addition to the theoretical analysis of collusion, we will consider the laws governing conspiracy and "bid-rigging". There is a second empirical mystery about conspiracy, which is that it typically occurs in industries with easy entry (movie theaters, road building, moving and storage, etc.), where presumably entry undermines the collusive profits.

8. Advertising

There are two major theories of advertising. In the burning money theory, a firm tries to signal that it has a good product by advertising more than the seller of a bad product could profitably do, i.e. signalling that it expects repeat business. Such advertisements need not have any content: they are just supposed to be expensive. Price advertising may yield imperfectly informed consumers, and in many such models, the equilibrium involves randomized prices, which gives a model of sales.

9. Entry and Exit

A classic issue in IO is the deterrence of entry and the encouragement of exit by pricing decisions. This will be analyzed using the game theoretic tools developed for pricing behavior. The modern formulation of the entry deterrence theory involves an incumbent who knows more about the cost or demand than a potential entrant, and the entrant uses the incumbent's price as a signal of this cost or demand, creating an ability for the incumbent to deter entry by changing his price. However, the entrant understands this ability as well. The analysis of this question originated with court decisions on predatory pricing: could firms profitably drive their rivals out of business, and then enjoy monopoly profits? If consumers were hurt by this behavior, it would be illegal under the Clayton Act.

10. Product Differentiation and Patents

Offering a different product than other firms creates a degree of market or monopoly power. Natural questions concern how firms behave when they can differentiate their products. Do they produce too many or two few different products? Can product differentiation act as a barrier to entry (spatial preemption)? A patent creates a temporary monopoly, which creates an incentive for firms to invest in research to win a patent race. Will firms invest too much or too little in these races?

 

11. Auctions and Bidding

The issue of how prices are set in imperfect competition is a fundamental issue for understanding how markets work. Auctions provide one important model of price determination. A significant aspect of behavior in auctions concerns how a bidder thinks about his rivals' behavior, because a given bidder typically does not know the rivals' values for the good. One example of this strategic interaction is the winner's curse, which, simply stated, means that the bidder who most overvalues the object for sale will win the bidding. This means that bidders must bid well below their estimate of the value, for the fact that other bidders will not pay this price is evidence that the object has low value. How does the expected price varies with the number of bidders? What are the effects of providing information about the value of the good on bidding? What are the effects of revealing the number of bidders on the bidders? What are the effects of setting an entry fee or a reserve price?

12. Agency Theory

Agency theory, or principal-agent models, is an important tool for understanding contracting. There are two main types of agency model. In the first, a risk-neutral principal (e.g. insurance company) contracts with a risk-averse agent. The contract must balance risk-sharing (the principal is more efficient at absorbing risk) with the agent's incentive to exert effort (a contract in which the agent's payoff is constant puts all the risk on the principal, but gives the agent no incentive to exert effort). In the other class of models, both the principal and the agent are risk-neutral, but the agent knows more about his cost of effort than the principal. As a consequence, the agent earns informational rents from the contract (low cost agents can act like high cost agents, thereby being paid more than their cost), and the principal has an incentive to distort the agent's effort to reduce the informational rents, and full information efficiency is not obtained. Several results emerge from this analysis. More able agents work harder, and only the best possible agent has a full-information efficient contract. More able agents have higher commissions and lower salaries than less able agents. Agency theory is also the theory of optimal taxation.

13. Insurance

A risk neutral insurer offers insurance to an agent, who knows his own riskiness, and the insurer does not. This is the classic asymmetric information model, simple to solve, and illustrates many of the effects of asymmetric information: an full-information efficient contract only for one possible type of agent, inefficiently little insurance for others.

14. Bilateral Bargaining and The Market for Lemons

A buyer and seller each know their value of an object that the seller holds, but do not know the other's value. It turns out that there is no mechanism for achieving efficient trade; that is, it is not possible for these two to trade whenever trade is socially optimal, because each has an incentive to distort the mechanism to improve the terms of trade. In a dynamic context, this leads to delay in trade. The general thrust of this topic is to understand how markets work when information is not available to all.