What is the old empirical IO?

1. Lecture #11: Introduction to the New Empirical Industrial Organization (NEIO)modified from:http://spirit.tau.ac.il/public/gandal/lecture11i.pdf • What is the old empirical IO? • The old empirical IO refers to studies that tried to draw inferences about the relationship between the structure of an industry (in particular, its concentration level) and its profitability. • Problems with those studies are that • it is hard to measure profitability, • industry structure may be endogenous, and • there is little connection between empirical work and theory. • The NEIO is in many ways a reaction to that empirical tradition. NEIO works “in harmony” with (game) theory.

2. The Structure-Conduct-Performance (SCP) Paradigm: The Old Empirical IO • How does industry concentration affect price-cost margins or other similar measures? • The “plain vanilla” SCP regression regresses profitability on concentration. • The Cournot model of non-cooperative oligopolistic competition in homogeneous product industries relates market structure to performance. • It can be shown that shared weighted average markup in an industry is a function of its Herfindahl index and the elasticity of demand.

3. This implies:ln(PCM) = 0 + 1 ln(HHI) + 2 ln() +  (1) where PCM = the share weighted average firm markup. • Using cross section data, (1) could be estimated and a test for Cournot would be 0 = 0, 1 = 1, and 2 = -1. • In practice, regressions of the following form were performed:ln(PCM) = 0 + 1 C4 +  (2)where C4 was the share of the four largest firms in the industry.

4. What are the problems with these regressions? • Data: Price cost margins are not available, hence accounting returns on assets (as well as census data on manufacturer margins) were often used. • Data: Additional RHS variables such as the elasticity of demand are hard to measure for many industries. • Data: Market definitions were problematic. (When using a single industry more thought can be put into the issue.) • Simultaneity: Both margins and concentration are endogenous.Demsetz (J. Law and Econ., 1973) noted that some firms have a cost advantage, leading to a large share and high profits. Hence, there could be a correlation between C4 and profits.

5. The New Empirical Industrial Organization (NEIO) Paradigm: The New Empirical IO • The NEIO studies • build on the econometric progress made by SCP paradigm, • use economic theory, • describe techniques for estimating the degree of competitiveness in an industry, • use bare bones prices and quantities, and do not rely on cost or profit data, • typically assume that the firms are behaving as if they are Bertrand competition, • use comparative statics of equilibria to draw inferences about profits and costs, and • focus mainly on a single industry in order to deal better with product heterogeneity, institutional details, etc.

6. Bresnahan (Economic Letters, 1982): The Oligopoly Solution Concept is Identified This paper and others (e.g.,A. Nevo, “Identification of the Oligopoly Solution Concept in a Differentiated Products Industry,” Economics Letters, 1998, 391-395) show that the oligopoly solution concept can be identified econometrically. • Demand: Q = 0 + 1 P + 2 Y +  (1)MC: MC = 0 + 1 Q + 2 W +  (2)where Y and W are exogenous. • FOC for a PC firm: MC = P ( MR is: P) FOC for a monopoly: MC = P + Q/1 ( MR is: P + Q * P/Q) FOC for the oligopolistic firm: MC = (1 - ) P +  (P + Q/1)where  = 0 if the industry is competitive  = 1 if the industry is a monopoly

7. Demand: Q = 0 + 1 P + 2 Y +  (1) MC: MC = 0 + 1 Q + 2 W +  (2)FOC: MC = (1 - ) P +  (P + Q/1) • Substituting FOC into (2), the supply relationship is:(1 - ) P +  (P + Q/1) = 0 + 1 Q + 2 W +  • P =  (- Q/1 ) + 1 Q + 0 + 2 W +  (3) • Since both (1) and (3) have one endogenous variable and since there is one excluded exogenous variable from each equation, both equations are identified. But, are we estimating P = MC (competitive) or MR = MC (monopoly)? Rewrite (3) as: P = (1 -  /1)Q + 0 + 2 W +  We can obtain a coefficient for (1 -  /1)since (3) is identified and we can get 1 by estimating (1). But, we cannot estimate 1 and . Identification problems!!!

8. E2 MCM E1 D2 D1 MR1 MR2 • In the figure, E1 could either be an equilibrium for a monopolist with marginal cost MCM, or for a perfectly competitive industry with cost MCC. • Increase Y to shift the demand curve out to D2 and both the monopolistic and competitive equilibria move to E2. • Unless we know marginal costs, we cannot distinguish between competitive or monopoly (nor anything in between). MCC

9. The solution to the identification problem • MC: MC = 0 + 1 Q + 2 W +  (2) • Let demand be: Q = 0 + 1 P + 2 Y + 3 P Z + 4 Z +  where Z is another exogenous variable. The key is that Z enters interactively with P, so that changes in P and Z both rotate and vertically shift demand. (Note: Z might be the price of a substitute good, which makes the interaction term intuitive.) • Given the new demand, the marginal revenue for a monopolist, (P + Q * P/Q), is no longer P + Q/1. It is now: P + Q / (1 + 3 Z). • Thus, the oligopolistic firm’s FOC becomes MC = (1 - ) P +  [P + Q / (1 + 3 Z)] • Substituting FOC into (2), the supply relationship becomes:P = -  [Q / (1 + 3 Z)] + 1 Q + 0 + 2 W +  -  Q* + 1 Q + 0 + 2 W + 

10. Demand: Q = 0 + 1 P + 2 Y + 3 P Z + 4 Z +  Supply Relation:` P = -  [Q / (1 + 3 Z)] + 1 Q + 0 + 2 W +  -  Q* + 1 Q + 0 + 2 W +  • Since the demand is still identified, we can estimate 1 and 3. Thus, we can identify both  and 1 in the supply relation. • Note 1: This result can be generalized beyond linear functions. Note 2: There are other assumptions that can generate identification. e.g. Marginal cost that does not vary with quantity (1 = 0) e.g. Use of supply shocks (Porter, 1983)

11. MCC E1 MCM D1 MR1 • Graphically, an exogenous change in the price of the substitute rotates the demand curve around E1. • If there is perfect competition, this will have no effect on the equilibrium price and it will stay at the point associated with E1. • But, if there is monopoly power, the equilibrium will change to E3. E2 D2 MR2

12. Why do we care about the structural model? • We want to estimate parameters or effects not directly observed in the data (e.g., returns to scale, elasticity of demand). • We want to perform welfare analysis (e.g., measure welfare gains due to entry or welfare losses due to market power). • We want to simulate changes in the equilibrium (e.g., impact of mergers). • We want to compare relative predictive performance of competing theories.