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Industrial Organization - Matilde Machado. Introduction. 4. Syllabus of the course. 4. Product Differentiation. 1. Definitions. [Cabral, Luis ]. 2. Horizontal. Luis Cabral has updated his industrial organization textbook. The revision retains the strengths of the original: it is clear and succinct, with an emphasis on how. Introduction to industrial organization / Luís M.B. Cabral. Author. Cabral, Luís M. B., (author.) Edition. Second edition. Published. Cambridge, Massachusetts.

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In most modern corporations. This considerably decades or so. At one extreme. From a theoretical point of view. For these reasons. A critical result from agency theory is that. Because managers. Under this solution. Even if shareholders can and are willing to control managers. Such contracts attenuate the agency problem of separation between ownership and management. Agency theory is the area of economics that deals with this class of strategic interaction.

In the preceding example. Evidence from the U. The board of directors has the discretion to appoint managers. At the opposite extreme. On the independence of boards of directors. A board of directors is more independent the lower the number of insiders it includes. Broadly speaking. These results are consistent with the following interpretation.

The independence of the board of directors is the result of a negotiation process between the CEO and the shareholders. Insiders are those who either work in the company as managers or are otherwise close to the CEO. What determines the relative composition of boards of directors? Consider the following empirical results: This reputation effect may help to provide managers with the proper incentives.

The Firm Box 3. Outsiders are those who bear no relation to the company or the CEO. Lloyds TSB has acquired the reputation for being the most thrifty large bank in the world. Box 3. Capital Market Discipline d Exercise 3. Under intense market competition.

In a monopoly situation. As a result of this cost-cutting policy. In that case. The idea is that. The idea is quite simple: Lloyds received a net return of One possible answer is that the raider possesses information that shareholders do not: An example of this also from the banking industry.

Based on a cross section of states. Explained variable Explanatory variable Takeovers are allowed in state 1 if yes. Banking Industry32 Banking regulation varies considerably throughout the United States.

Shareholder concentration. It may be useful to divide this into two questions: By horizontal extension. Volkswagen would increase the degree of vertical integration if it were to acquire a tire manufacturer.

Production costs are related to plant operation. This implies that there is a range of output levels that attain the minimum average cost. If average cost is Ushaped and there is free entry into the industry. Volkswagen increased its horizontal stretch.

These reasons include management incentive contracts. Plants of much smaller size or much larger size would probably incur a higher average cost and be unable to survive for very long. Suppose there is a unique output level that minimizes plant average costs.

By vertical integration. We should point out. Although management and ownership are normally separated. If so. General Motors was unhappy with the contractual terms and proposed to renegotiate them.

As it turned out. Continuing with the example of GM. It was clear to both parties that the switch to metal bodies. Unlike wooden bodies. It becomes. An Let us start with a classical case study. Why do we observe a great degree of vertical integration in some industries and very little in others?

The degree of vertical integration in a given industry results from the aggregation of these micro decisions at each stage of the production process. The cost for Fisher Body to switch to a different downloader would now be enormous. During the wooden-body era. But vertical integration does not solve all incentive problems. Once Fisher Body invested in machinery for producing GM bodies. General Motors decided to acquire Fisher Body. Understanding that this situation could not be sustained.

The idea was that. A second intermediate system is that of franchising. One possibility is that of tapered integration.. The extremes of both complete vertical integration and complete vertical separation imply incentive problems. Examples of tapered integration include soft-drink bottling for the Coca-Cola and Pepsi-Cola companies. Xerox was the dominant player in the photocopier industry thanks to its patent on plain-paper photocopying. It may be useful to consider the analogy with car racing.

Most of the features of any given organization are tacit knowledge. In the late s and early s. Most features of Formula One cars are not patented. Formula One racing. In order for the Arrows team to match the performance of the Ferrari team. In these cases. Empirical observation suggests.

One rather obvious explanation is that not all drivers have the same ability. Strategic or tactical decisions include whether to stop once or twice during the race. Once Xerox started licensing its technology. The Firm industries. In strategy jargon. In the meantime. When Lockheed tried to get back in the game.

In retrospect. One important aspect of competition in this industry is the existence of a steep learning curve: The point is that sometimes. For now. Of the three sources of competitive advantage listed earlier. We resume this discussion in chapter The name of the game is therefore to move down the learning curve as quickly as possible. Let us consider an example. Other examples could be found. Firms are different because of impediments to imitation. In conjunction with all of the preceding factors.

Airbus appeared in the scene. The three competitors were Boeing B McDonnell Douglas did not have much better luck. But again. This is not to say that the other ones are not important. In a business context. Firm performance varies a great deal. At the start. McDonnell Douglas.

McDonnell Douglas DC But in the early s. Chapter 3 Lockheed exited react to the choices made by rival teams. Which of these parts is a car company more likely to manufacture in-house? What are the main trade-offs? The Firm Summary. All stores that are distant from headquarters by more than miles are franchised. All three maintain extensive support staff at major and many minor airports throughout the world. Why do all three feel they need to provide service and support operations worldwide themselves?

Extension Exercises 3. General Electric. Body Shop franchise network consists of three types of stores— franchised. More than half of the companyowned stores are within miles of headquarters. Indicate the explanatory power of the different causes considered in the text impediments to imitation.

What does section 3. It is important to keep this point in mind when judging the very stylized nature of some of the games and models presented in this text. It has two alternatives to choose from: In summary. If that happens. This type of situation introduces a number of important considerations.

Economists study this type of situations as if Time and Newsweek were playing a game. The optimal choice for a player—its optimal strategy—depends on what it conjectures other players will choose.

Being stylized is not a defect of models. A game is a stylized model that depicts situations of strategic behavior. A completely realistic model would be as useful as an exceedingly detailed description of reality. Models are stylized representations of reality. Because other players act in a similar way. This form of representing games is know as normal form. It is therefore important to clarify its precise meaning.

There are two players. Player 1 has two possible strategies. Player 2 also has two possible strategies. L and R. In real life. So how realistic is the assumption that players choose strategies at the same time? Suppose that there is an observation lag. Later in the chapter. Player 1 and Player 2.

A game consists of a set of players. In this context. This rule will be maintained throughout a number of examples in this chapter—in fact. For each combination of strategies by each player.

Figure 4. The basic element of game theory and applied game theory is a game. T and B. B would yield a payoff of 6. What is interesting about this game is that 1 both players are better off by choosing T. If Player 1 expects Player 2 to choose L. What strategies would we expect players to choose? Games and Strategy 4.

In this case. There are no dominant strategies in this game. The same is true for the cases when Player 2 chooses C or R.

If a player has a dominant strategy and if the player is rational. Player 1 has a dominated strategy. Although Player 1 has no dominant strategy. Chapters 7 and 8. R and receive 4. M is also dominated by T. Notice that all we need to assume is that the player is rational. The concept of dominant strategy is very robust.

Given that Player 1 does not choose M. C is not a dominated strategy: If Player 1 chooses M. We can now take this process one step further. If Player 1 is rational. Player 1 is better off with B 2 instead of 1. Notice that. This leaves us with the pair of strategies B. To understand the importance of these assumptions regarding rationality. Player 2 should expect Player 1 not to choose M. C is dominated by L or R given that M is not played by Player 1.

By the reasoning presented above. Something more can be said. Player 2 has a dominated strategy. If Player 2 chooses L.

If Player 1 has a dominant strategy. Is there anything we can say about what to expect players will choose? In this game. There are no dominant or dominated strategies in this game. Given this belief. It is not only important whether players are rational. A more general point is that. Games and Strategy Figure 4. If Player 1 believes that Player 2 is rational. It is also important whether players believe the other players are rational. Then B may no longer be its optimal choice.

Contrary to the choice of dominant strategies. L and B. Strategies T and L. R are Nash equilibria. The same is true for Player 2. Player 1 would rather choose T. Given these conjectures. It can be checked that. C is not a Nash equilibrium because.

A possible illustration for this game is the process of standardization. This situation is referred to as a Nash equilibrium. Player 1 prefers compatibility around the standard B-R. A pair of strategies constitutes a Nash equilibrium if no player can unilaterally change its strategy in a way that improves its payoff.

Both players are better off under compatibility. Suppose that Player 1 conjectures that Player 2 chooses R. R is a Nash equilibrium and no other combination of strategies is a Nash equilibrium. At this node. Given that Player 2 chooses r.

The game starts with decision node 1.

If Player 1 chooses e. Given the decision of whether or not to enter. A game tree is like a decision tree except that there is more than one decision maker involved. If the latter is chosen. Consider the example of an industry that is currently monopolized. Games and Strategy 55 of a class of games in which 1 players want to coordinate.

The best way to model games with sequential choices is to use a game tree. It follows that r is an optimal strategy though not the only one. As for Player 2. Problems of standardization are further discussed in chapter In such a situation. Games which. Although the two solutions are indeed two Nash equilibria. In this setting. But suppose that Player 2 writes an enforceable and non renegotiable contract whereby.

Such threat is not credible because. Equilibria that are derived in this way are called subgame-perfect equilibria. Player 2 chooses r. If Player 1 were to enter. The Sequential-Entry Game. By retaliating.

Suppose that. Because this game is a part of the larger game. The contract is such that. Player 2 is better off playing the left-hand-side subgame than the right-hand-side subgame. Payoffs are the same in every case except one.

As we then saw. If anything strategy b. This cost may result from breach of contract or from a different cause.

Let us solve the left-hand-side subgame backward. Games and Strategy 57 Figure 4. Player 2 would incur a penalty of If we believe that Player 2 is credibly committed to choosing r.

The second point illustrated by the example is a methodological one. To conclude this section. This is when the game under consideration Figure 4. This example illustrates two important points. The alternative. The value of commitment is 30 in this example. In so doing. And this is precisely what we get by placing the short-run choice in the second stage.

In a real-world situation. When modeling this sort of strategic interaction. If we want to model this in a simple. This is not as complete and rigorous as the normal-form and extensive-form representations we saw before.

Short-run variables are those that players choose given the value of the long-run variables. In the following chapters. The same principle applies generally when there are long-run and short-run strategic variables.

Direct inspection reveals that this game has two Nash equilibria: In repeated games. Although this third strategy leads to an extra Nash equilibrium. A strategy for Player 1 has to indicate what to choose in period 1 and what to choose in period 2 as a function of the actions that were taken in period 1.

We are referring only to equilibria in pure strategies. Player 1 has 3 times 3 to the power of 9. B for Player 1. C and B. In one-shot games. R for Player 2. Now suppose that this one-shot game is repeated twice. Because in this game each player chooses one action only once.

In each period. The best Nash equilibrium yields each player a payoff of 4. Does this proliferation of strategies add anything of interest that was not present in the one-shot version of the game? In many cases. Player 1 still has three actions to choose from. In period 2. The interesting question is whether there are equilibria of the repeated game that do not correspond to equilibria of the one-shot game. Consider the following strategy for Player 1: Games and Strategy of the repeated game.

A similar comparison is obtained if we consider other deviations from the designated strategies by either Player 1 or Player 2. The implicit strategies that lead to such equilibrium of the repeated game are.

Period 1 payoff would then be 6. Take Player 1: Choosing the action T. L is part of an equilibrium in the two-period game. In words. Because the latter also constitute an equilibrium of the one-shot game. Player 1 chooses M instead. C in both periods is an equilibrium. Let us now check that these strategies constitute an equilibrium of the repeated game. Although this cannot be sustained in a one-shot game—both players would have an incentive to deviate—an arrangement can be made whereby T.

We conclude that the designated strategies constitute a Nash equilibrium. Total payoff is therefore 9. Because these actions form a Nash equilibrium of the one-shot game. R in period 2. Total payoff would therefore be 7. Now suppose that.

Player 2 is playing the designated strategy L in period 1.

C in period 2. In analyzing games. Such procedure excludes strategies that are not credible. The equilibrium of a game indicates the strategies that one would expect players to choose. A game is a model that depicts a situation of strategic behavior.

Sequential games should be solved backward. Games may be represented in normal form matrix or in extensive form game tree. Committing to take a future action which is ex-post suboptimal may have an ex-ante strategic value. As we see in chapter 8. Simultaneous strategy choices should not be interpreted literally: The second version of the game corresponds to the assumption that Time is a more h In each cell.

As the payoff matrix suggests. Show how the tactic initiated by the U. Since its introduction in Nash equilibrium. Games and Strategy. In the United States. Department of Justice. Contrast this with the case of dominant strategies. Determine whether the game can be solved by dominant strategies. Mars turned down the offer.. As a result of the publicity created by this scene. The makers of E. Determine all Nash equilibria.

For each of the three versions of the game. Indicate clearly which assumptions regarding rationality are required in order to reach the solutions in a and b. Search Search. Search Advanced Search close Close. Preview Preview. Cabral An issue-driven introduction to industrial organization, thoroughly updated and revised.

Not for sale on the Indian subcontinent. Request Permissions Exam copy. Overview Author s Praise. Summary An issue-driven introduction to industrial organization, thoroughly updated and revised.

Instructor Resources Downloadable instructor resources available for this title: Share Share Share email. Authors Luis M. Endorsements Luis Cabral has updated his industrial organization textbook. Robert Porter William R. Ariel Pakes Thomas Professor of Economics, Harvard University; editor, Microeconomic Insights Cabral introduces the theoretical ideas and frameworks of contemporary IO expertly, succinctly, and with flair. Michael H. The point is that there are some industries where market power exists to a signicant extent.

Market power translates into higher prots. Creating and maintaining market power is therefore an important part of a rms value-maximization strategy. How do rms acquire market power? One way is through legal protection from competition, so that high prices can be set without new competitors entering the market. For example, in the s, Xerox developed the technology of plain-paper photocopying and patented it.

Given the legal protection provided by Xeroxs patents, it could raise prices to a signicant level without attracting competition see box Firm strategy may also play an important role in establishing market power. Its competitors include ONdigital, which is based on terrestrial broadcasting, and a consortium of cable operators. Still, there is concern that BSkyBs move may trigger a price war that could hurt the prots of every rm in the industry.

In fact, ONdigital reacted by saying it also will provide free set-top boxes. Creating market power is only one part of the story. A successful rm also must be able to maintain market power.