Industrial Organization: Monopoly, Competition, and Strategy

Posted on Oct 7, 2025 in Economics

Early Models of Industrial Organization

  • Cournot (1838): Used mathematics to study economics, price formation with a single supplier (monopoly), and oligopoly with simultaneous quantity setting.
  • Bertrand (1883): Analyzed oligopoly with simultaneous price setting.
  • Stackelberg (1934): Studied sequential setting of quantities in an oligopoly.
  • Hotelling (1929) and Chamberlin (1933): Introduced the concept of product differentiation.

Schools of Thought in Industrial Organization

The Harvard School (1940s)

Key figures include Bain, Mason, and Galbraith. This school emphasizes empirical work.

  • Market structure (entry barriers, concentration, product differentiation) is key to identifying market conduct and its resulting performance.
  • This relationship is known as the Structure → Conduct → Performance (SCP) paradigm.
  • It promotes public intervention in the market structure to obtain desired results.

The Chicago School (1950s)

Key figures include Stigler, Posner, Peltzman, and Demsetz.

  • The perfect competition model is a good approximation of how markets operate in the absence of public intervention that imposes entry barriers.
  • Market power, if it exists, is temporary due to the threat of new firms’ entry.
  • The government should generally not intervene in market regulation.

The European (Austrian) School (60s-70s)

Influenced by Schumpeter (1934, 1942), with other figures like Scherer, Jacquemin, and Segura.

  • Emphasis is placed on the dynamic aspects of the economy.
  • Market power is considered temporary in an economy in constant progress.
  • The economy is viewed as a process of creative destruction.
  • The expectation of achieving a dominant position is an incentive for firms to improve their products and processes.

The New Industrial Organization (1980s)

Led by figures like Tirole, this is the dominant vision today.

  • It recaptures the SCP paradigm while incorporating new ideas from later schools, such as potential competition and dynamic aspects.
  • It introduced significant methodological progress through:
    • Theory: Application of Game Theory.
    • Empirical Work: Use of advanced Econometric tools.

The Structure-Conduct-Performance (SCP) Paradigm

The SCP paradigm is a system of market analysis that systematizes and articulates the relevant aspects of Industrial Organization. The core idea is that every sector is characterized by its structure, the conduct (behavior) of the firms within it, and a list of indicators that measure its performance (results). All aspects are related to each other and are also a function of certain exogenous conditions, such as technology, demand structure, or public intervention.

Measuring Market Structure and Power

Hannah and Kay Criteria (1977)

These are criteria for a good market concentration index:

  • Classification Criterion: An index must classify an industry as more concentrated than another whenever the first’s concentration curve is always above the second’s.
  • Entry Condition: If a small firm joins an industry, concentration should decrease, while the same firm leaving should increase concentration. The opposite is true for a large firm.
  • Transfer of Sales Principle: A transfer of sales from a small firm to a large one should increase concentration, and vice-versa.
  • Merger Condition: The merger of two or more firms should increase concentration.

The Lerner Index

The Lerner Index is a way to measure a firm’s market power and, by extension, a market’s inefficiency. It is equivalent to the inverse of the price elasticity of demand.

Monopoly Theory and Pricing

Natural Monopoly

A natural monopoly exists when it is most efficient for a single firm to produce for the entire market. This can be defined in two ways:

  • Definition A) Increasing Economies of Scale: The average cost of production is decreasing as output increases. The more units the firm produces, the smaller the unit cost.
  • Definition B) Cost Sub-additivity Property: The cost for one firm to produce the total output is less than the combined cost of two or more firms producing the same total amount. (i.e., C(q) < C(q1) + C(q2) where q = q1 + q2).

Price Discrimination Strategies

First-Degree (Perfect) Price Discrimination

Each unit of a product may be sold at a different price. The monopolist sells units until the marginal cost intersects the demand function, achieving productive efficiency (q = q_pc). The total surplus is maximized, but the producer captures all of it, leaving zero consumer surplus.

Second-Degree Price Discrimination (Self-Selection)

The monopolist does not distinguish between consumer types but knows the distribution of population characteristics. By offering different quantity/price packages (tariffs), the monopolist allows consumers to self-select. The monopolist can choose to serve all consumers or only the high-demand group. The group with a higher price elasticity of demand will face a lower price.

Third-Degree Price Discrimination (Group Pricing)

The monopolist distinguishes consumers among well-defined groups and charges different linear prices to each group. This is feasible when arbitrage between groups can be prevented. It is equivalent to operating as a traditional monopoly in two or more separate markets.

Collusion and Strategic Interaction

Factors Facilitating Collusion

  • The Discount Factor: For a given number of firms, collusion is easier to sustain when the discount factor is high. This means the future is more important, making the punishment for deviation more severe.
  • The Number of Firms (n): For a given discount factor, collusion is easier to sustain with fewer firms, as it is more profitable to share monopoly profits among a smaller group.

Product Differentiation Principles

  • Principle of Maximal Differentiation: If firms compete on price, they choose to differentiate their products from each other as much as possible.
  • Principle of Minimal Differentiation: If firms take prices as given, they have incentives to differentiate as little as possible from each other.

Market Entry Barriers and Strategy

Definitions of Entry Barriers

  • According to Bain: Entry barriers exist as long as incumbent firms can set a price above their marginal costs without attracting new entrants.
  • According to Stigler: Entry barriers are costs that incumbent firms do not have to bear but which potential entrants must incur.

Strategic Entry Scenarios

  • Blockaded Entry: The potential entrant does not enter, even when the incumbent takes no action to prevent entry. The incumbent acts as if there were no entry threat.
  • Accommodated Entry: The potential entrant enters regardless of the incumbent’s actions. In this case, the incumbent will not try to prevent entry and will accommodate the new firm.
  • Deterred Entry: The potential entrant does not enter because the incumbent has altered its strategy specifically to prevent entry.

Corporate Mergers

Horizontal Mergers

According to the Chicago school (Stigler), after a horizontal merger:

  • Market concentration increases, which can reduce consumer surplus.
  • The market share and profits of non-merging firms increase.
  • The market share of the merging firms is reduced. For a voluntary merger to be profitable, efficiency gains must offset this loss of market share.
  • Non-merging firms react to the merger by expanding their production. This is known as the “free-riding” effect, which merging firms suffer from and non-merging firms benefit from.

Vertical Mergers

Vertical mergers, unlike horizontal ones, can be privately profitable and socially optimal simultaneously, even without cost synergies. The primary benefit is that the merger prevents double marginalization, where successive monopolies in a supply chain each add their own markup, leading to a higher final price than a single integrated monopoly would charge.