Industry Empirical Studies Differentiated Products Structural Models - Applications

1. IndustryEmpirical StudiesDifferentiated Products Structural Models - Applications Base on the lectures of Dr Christos Genakos University of Cambridge

2. OUTLINE • International Price Discrimination – Verboven (1996) • Benefits of New Products – Petrin (2002) • Horizontal Mergers – Nevo (2000), Genakos (2004)

3. Verboven (1996): international price discrimination • European car market • Concentrated industry: C4>53(Belgium)-78(Italy)%, with various degrees of international penetration (Japan, Korea) • Controlling for observed characteristics pre-tax prices differ significantly across countries (table 1) • Special treatment under EU regulation for selective and exclusive dealers network • Extremely difficult to purchase a car abroad and import it • Question: are these differences due to cost differences or due to third degree price discrimination?

4. Empirical Framework • Demand model is assumed to be a Nested Logit model with unobserved characteristics: allows to model correlation between groups of similar products in a simple way→ easy to estimate • where this looks very much like the simple Logit apart from the additional parameter σ that captures the correlations of products within groups and sj/g is the observed mkt share of product j in category g. • Verboven uses two nests defined by class (mini & small, medium, large, executive, luxury and sports) and country of origin (domestic vs foreign)

5. Empirical Framework • Supply model: multi-product firms each producing a portfolio of products • Also incorporates import quotas (important for Japanese and Korean cars) • IV: since the characteristics are assume exogenous in the short run, functions of these characteristics across other cars owned by the same firm and across other cars not owned by that firm (averages here). The idea here is that the more tightly packed is the characteristic space around you the more constraint you are in terms of your pricing (when that would not be valid?) • Data: Car models from five EU countries in 1990, their characteristics and other institutional variables (exchange rates etc)

6. Results and Discussion Results: table 2 and table 3 • Substantial markups for domestic cars • Higher markups for japanese cars when import quota is binding • More expensive cars have higher markups Discussion • need to pre-specify the relevant groups, correlation between brands within a group higher than across groups • substitution within groups still driven by market shares like in Logit • the order of the nests matter

7. OUTLINE • International Price Discrimination – Verboven (1996) • Benefits of New Products – Petrin (2002) • Horizontal Mergers – Nevo (2000), Genakos (2004)

8. Petrin (2002): Benefits of new products • Introduction of Minivan 1984 (story about DelaRussa from Ford to Chrysler and station wagons). • Methodology: estimate a demand and cost system from the observed data and then re-compute equilibrium prices and quantities from a choice set that does not include the Minivan • fundamental problem is that the other cars produced might not have been the same had the Minivan not been introduced, but we have to start somewhere.

9. Petrin (2002): Benefits of new products • Uses the same demand and cost specification as BLP but adds some micro first-choice moments from CEX, by adding moment restrictions corresponding to purchase probabilities interacted with individual characteristics (income group) and interactions of individual characteristics with car characteristics (family size) • IV: since the characteristics are assumed exogenous in the short run, functions of these characteristics across other cars owned by the same firm and across other cars not owned by that firm.

10. Results and Discussion Results: • More precisely estimated coefficients with the additional moments and more reasonable estimated markups (table 5 and 9) • Significantly larger markups for minivans relative to other new vehicles (table 10) • Significant gains for Chrysler and consumers (table 11) • Substantial welfare gains from the minivan innovation (table 13) Discussion • Additional data (CEX) only available for particular goods; functional form assumptions

11. OUTLINE • International Price Discrimination – Verboven (1996) • Benefits of New Products – Petrin (2002) • Horizontal Mergers – Nevo (2000), Genakos (2004)

12. Merger Analysis • Merger activity has increased dramatically over the last decade (e.g., in 1998 US regulators reviewed 4,728 cases with a value that exceeded $1 trillion) • Theory suggests that a merger increases firms' market power, leading to higher prices (absent any efficiency gains) • The effect on total welfare (producer + consumer surplus) is ambiguous • Antitrust authorities ought to be protecting consumer welfare or economic efficiency? • The extent to which prices rise is an empirical question

13. Merger Analysis (pre 1990's) Structure-Conduct-Performance literature paradigm: Define Markets → Compute market shares → Threshold tests for presumption of illegal Problems: Market definition: which products to group together? which geographic areas to group together? Mode of competition: Static or dynamic? Nash in prices or quantities? Nothing else changes in response to the merger: cost cutting? internalising network externalities or advertising & marketing? entry? investment?

14. Merger Theory – Merger Simulation • Incentives to merge: strategic complements (price) implies that a merger is more likely to be profitable, than when strategic substitutes (quantity). • The whole issue is to balance the anti-competitive effects of mergers with the efficiency gains they bring →need to quantify these in an equilibrium framework Merger Simulation Framework: • Estimate demand, supply and market power BEFORE the merger • Change the market structure and calculate equilibrium prices AFTER the merger • Simulate the effects of a merger → welfare analysis

15. Empirical Framework Given the product ownership structure before the merger (Ωpre), marginal costs (in vector notation) are given by These calculations are based upon the demand coefficients' consistency and the equilibrium assumption For the merger simulation, use the same equilibrium assumption and the new (post merger) industry structure matrix (Ωpost). The postmerger equilibrium price vector, p*, solves:

16. Nevo (2000): mergers in ready-to-eat cereal industry Ready-to-eat cereal industry Very concentrated industry: C4>94%, leading sellers made very high profits consistently Various dimensions of differentiation: lots of new products but very few survive Interesting merger activity during the nineties: General Mills-Nabisco, cancelled; Post-Nabisco, allowed; General Mills-Ralston Purina, allowed. Question: what can we say about market power and welfare using the merger simulation framework?

17. Results • Table 2 (Demand): income makes you less sensitive but at a declining rate, we like sugar and mushiness and dislike fiber; richer people dislike sugar but like mushy cereals, kids hate fiber • Table 3: own and cross price elasticities • Table 4: marginal costs and margins • Table 5: changes in prices and quantities due to mergers • Table 6: what would be the reduction in marginal cost s.t. no change in postmerger prices? • Table 7: profits and welfare

18. Genakos (2004): mergers in PC industry • Evaluate the welfare effects of the biggest ($25 billion) merger in the PC industry's history between HP-Compaq, not only for the whole market but also for three different segments (home, small business and large business) • Similar framework and empirical methodology as Nevo (2000) • Quarterly data on prices and quantities from IDC 1995Q1-2001Q2 for the top nine PC manufacturers in the US • Characteristics (Speed, RAM, CD-ROM, Internet, Monitor Size, Desktop) of the PCs from various magazines. Unit of observation: Firm-Brand-Form-CPU-Speed • Unique information on the PC buyers' identity (home, small business and large business)

19. Estimated Markups and Margins for the whole market Financial Times: gross profit margins for the top PC manufacturers at 20% in 1996 and 10% in 1998.

20. Predicted changes in variable profits and consumer surplus due to HP-Compaq merger($m)

21. Predicted changes in variable profits and consumer surplus due to HP-Compaq merger($m)

22. Reality Check Critics of the merger like Mr. Hewlett insisted that competitors like IBM and Dell stand to gain the most from the merger. "HP's rivals raised almost no objections to the merger. We are not surprised”. (Red Herring, 8/5/2002)

23. Estimated Aggregate Elasticities • Considerable heterogeneity in preferences across segments • Validates the European Competition Commission’s view • Direct implications of the mergers effects on different segments

24. Predicted changes in variable profits and consumer surplus due to HP-Compaq merger across segments (2001)

25. Reality Check (The merger is best) seen as a defensive move in a shrinking industry" (The Economist, 29/9/2001). "Fiorina (CEO of HP) and other HP executives insist that they must sell PCs to compete for lucrative corporate customers" (The Boston Globe, 9/7/2003).

26. Conclusions • Demand estimation fundamental policy input element • Many interesting applications and policy relevant questions • Many empirical models to choose from, but need sensible structural framework that fits the industry idiosyncrasies • Need for dynamics

27. Studies on Price Discrimination, New Products and Mergers: References *Verboven, F. (1996) “International Price Discrimination in the European Car Market”, Rand Journal of Economics, 27:240-268 *Petrin, A. (2002) “Quantifying the benefits of New Products: The Case of Minivan”, Journal of Political Economy, 110, 705-729 *Nevo, A. (2000) “Mergers with Differentiated Products: The Case of the Ready-to-eat Cereal Industry”, Rand Journal of Economics, 31:395-421. Genakos, C. (2004) “Differential Merger Effects: The Case of the Personal Computer Industry”, LBS mimeo and STICERD wp No. EI/39.

28. Verboven (1996) Table 3

29. Petrin (2002) Table 9

30. Petrin (2002) Table 10

31. Petrin (2002) Table 11

32. Petrin (2002) Table 13