Answers to my IO pop quiz
Oct 26, 2016
6 minute read

I’ve seen an uptick in interest in vigorous antitrust enforcement lately in my Twitter feed. To be sure, monopolies are not usually ideal, but it’s not clear to me that breaking up big companies or preventing mergers is the best way to deal with shortcomings in competition.

In order to prompt a bit more careful thought about these matters, yesterday I used Twitter’s poll function to give a pop quiz on industrial organization to my followers. Here are the results and answers.

The deadweight loss of market power is due to the fact that higher prices discourage some consumers from purchasing goods. A consumer might value a good at more than the cost of making it. But if the markup is too high, they won’t buy it, and that’s inefficient.

The deadweight loss of inefficient production is much, much worse. Inefficient production also pushes up prices, and therefore it discourages consumers from purchasing goods in the same way that market power does. But in addition, inefficient production causes wasted resources along the whole range of output.

Market power creates a deadweight loss triangle. Inefficient production creates a deadweight loss trapezoid. That trapezoid is composed of the same deadweight loss triangle, plus a quadrilateral that is at least twice as large and potentially hundreds of times larger. Therefore, inefficient production is really bad.

This issue is relevant when thinking about Type I and Type II errors in antitrust policy. Let’s suppose that a competition authority makes a Type II error—say, it allows an anticompetitive merger to go through. That’s not ideal, but it results only in a deadweight loss triangle.

On the other hand, suppose that a competition authority makes a Type I error—it prohibits a merger in which synergies would improve efficiency of production. Then it’s creating a deadweight loss trapezoid, which is much worse.

Since Type I errors in antitrust policy are potentially orders of magnitude worse than Type II errors, we should be very cautious when using antitrust policy to block mergers or break up companies.

How did people do? There were three possible answers on the question, so random guessing would result in a 33% correct answer rate. In fact, the correct answer, inefficient production, was selected a little less than half the time.

Next question:

A perfectly price discriminating monopoly charges every customer just exactly what they are willing to pay for the good. They never lose a sale because the price is too high, but they never leave any money on the table either. This is clearly more profitable than a ho-hum non-discriminating monopoly that charges everyone the same price.

It’s also more efficient than charging everyone the same price. When a non-discriminating monopoly selects a price, it will price some people out of the market, even though they value the good at more than the cost of making it. A price discriminating monopolist doesn’t do this—it generates no deadweight loss at all (caveat: in partial equilibrium).

This question shows that profits or monopoly rents aren’t what’s bad about monopolies. What’s bad about monopolies is deadweight loss. Yet many people’s rhetoric suggests that what they are actually concerned about is profits. That’s the wrong focus.

This is a true/false question, so random guessing would result in a 50% correct answer rate. In fact, just short of 70% of respondents correctly chose false.

Last question:

I wish I could go back and edit this question to add an unstated assumption: constant marginal cost. Let’s work through this question with constant marginal cost and then see how the answer might be modified with different assumptions.

When firms set prices and can quickly scale production to produce arbitrary quantities, the lowest-price firm takes the whole market. This is called Bertrand competition. Bertrand competition is vigorous. Each firm is trying to charge one penny less than all the other firms are charging, and that results in firms bidding the price down to marginal cost (and negative profits). This occurs whether there are two firms or many firms.

Since we have assumed that fixed costs are positive, two firms are strictly preferred to many firms. Why would we want fixed costs to be incurred over and over again for many firms? Two firms are sufficient to produce vigorous competition, so we should only incur the fixed costs twice.

If the fixed costs are sufficiently large, we would only want to incur them once. We might prefer to forgo vigorous competition in order to economize on the fixed costs. An example of this is the Sirius/XM merger. We had two satellite radio companies each maintaining their own costly infrastructure in space to reach a limited market. It was more efficient for the companies to merge, reducing competition in the market for satellite radio, in order to consolidate satellite infrastructure.

Consequently, the answer I had in mind when I asked the question was “one or two, it depends” on the magnitude of the fixed costs. However, “many” is also a defensible answer given specific assumptions about marginal cost. Here is what you’d have to say:

Suppose that marginal costs are rapidly increasing with output. In that case, for any given price, firms will only produce a specific quantity of goods. If the market is large relative to that quantity and fixed costs aren’t too large, then many firms would be preferable to two.

In any case, this question shows that in many cases, one or two firms is the optimal number in an industry. This is particularly true in technology, in which the big costs are fixed—engineering and design—and marginal cost is fairly constant or even zero.

How did people do? There are four possible answers, so random guessing would result in a 25% chance of select if you admit one correct answer and 50% if you admit two. In fact, just over a quarter or around 60 percent got the right answers, depending again on which answers you count as correct.

The bottom line is that IO is fun! And also sometimes a bit counterintuitive or complicated. It’s simply not the case that the best thing for the economy is always to strictly review mergers or break up big firms. Monopoly rents aren’t always bad. And sometimes the best number of firms in an industry is one or two.

If we want more competition without the risk of making big antitrust mistakes, we should focus instead on the other side of competition: entry barriers. Eliminating anticompetitive regulations and reducing compliance costs will create more vigorous competition without any of the complications I have raised above. Unfortunately, it’s far more emotionally appealing to lower the status of big corporations directly than to trust in the unseen forces of shadow competition to do the trick.