Jean Tirole The Theory of Industrial Organization The MIT Press Campridge, Massachusetts London, EnglandSeventh printing, 1994 © 1988 Massadhusetts Institute of Technology All rights reserved. No part of this back may be reproduced in any form by any electronic mechanical means (including photocopying, recording, or information storpge and retrieval) without permission in writing from the publisher, ‘This book was #t in Palatino by Asco Trade Typesetting Ltd. in Hong Kong, and printed and| lbound by Hamilton Printing in the United States of America. Library of Congkess Cataloging-in-Publication Data Tirole, Jean: ‘The theory Includes bibl 1. Industrial 1. Title H1D2326.TS6 ISBN 0-262-2 industrial organization, igtaphies and indexes ganization (Economic theory) 1988 302.3'5 88-2700 r1-0 This book is based in part on a translation by John Bonin and Helene Bonin of Jean Tirole’s Concurrence Imparfaite.Contents Prefacd 3 The Theory of the Firm 15 Introdction 1 I What Is a Firm? 17 3 The Profit-Maximization Hypothesis 35 3 Supplementary Section: The Principal—Agent Relationship 51 Answers and Hints 55 References 56 I The Exercise of Monopoly Power 62 Introduction 63 — 1 Monopoly 65 11 Pricing Behavior 66 12 Cost Distortions 75 1.3 Rent-Seeking Behavior 76 14 Conduding Remarks 78 15 Supplementary Section: Durable Goods and Limits on Monopoly Power 79 Answers and Hints 88 Appendix: A Heuristic Proof of the Coase Conjecture 91 References 92 ee 2 Product Selection, Quality, and Advertising 95 24. The Notion of Product Space 96 2.2 Product Selection 100 23 Quality and Information 106 24 Advertising 1152.5 ‘oncluding Remarks 115 2.6 jupplementary Section: Repeat Purchases 116 nswers and Hints 126 eferences 129 3 rice Discrimination 133 31 erfect Price Discrimination 135 Rd ultimarket (Third-Degree) Price Discrimination 37 33 pens Arbitrage and Screening (Second- Degree Price Discrimination) 142 3.4 Concluding Remarks 152 3.5 supplementary Section: Nonlinear Pricing 153 nswers and Hints 163 References 166 4 ertical Control 169 4,1 |Linear Prices versus Vertical Restraints 170 42 Externalities and Vertical Control 173 43 Intrabrand Competition 181 44 |Interbrand Competition 185 45 |Concluding Remarks 186 46 |Supplementary Section: Competition-Reducing Restraints 187 Answers and Hints 198 References 201 a a8 Strategic Interaction 204 Introduction 205 Short-Run Price Competition 209 The Bertrand Paradox 209 Solutions to the Bertrand Paradox: An Introduction 211 5.3 Decreasing Returns to Scale and Capacity Constraints 212 54 Traditional Cournot Analysis 218 5.5 Concentration Indices and Industry Profitability 221 56 Concluding Remarks 223 5.7 Supplementary Section; Quantity Competition 224 Answers and Hints 234 References 237 6 Dynamic Price Competition and Tacit Collusion 239 61 Conventional Wisdom (Factors Facilitating and Hindering Collusion) 240 62 Static Approaches to Dynamic Price Competition 243 63 Supergames 245 64 Price Rigidities 253 6.5 Reputation for Friendly Behavior 256 66 Concluding Remarks 261 6.7 Supplementary Section: Dynamic Games and Tacit Collusion 262 Answers and Hints 271 References 274 SS SS eS 7 Product Differentiation: Price Competition and Non-Price Competition 277 7.1 Spatial Competition 279 IR: Monopolistic Competition 287 73 Advertising and Informational Product Differentiation 289 7.4 Concluding Remarks 295 7.5 Supplementary Section: Vertical Differentiation Contents and Monopolistic Competition 296 Answers and Hints 300 References 3028.1 8.2 83 84 8.5 8.6 91 92 9.3 94 9.5 9.6 7 9.8 99 10 10.1 10.2 10.3 10.4 Entry, Accommodation, and Exit 305 Fixed Costs: Natural Monopoly and Contestability 307 Sunk Costs and Barriers to Entry: The Stackelberg-Spence-Dixit Model 314 A Taxonomy of Business Strategies 323 Applications of the Taxonomy 328 Epilogue: Prices versus Quantities 336 Supplementary Section: Strategic Behavior and Barriers to Entry or Mobility 338 Answers and Hints 352 References 356 Information and Strategic Behavior: Reputation, Limit Pricing, and Predation 361 Static Competition under Asymmetric Information 362 Dynamics: A Heuristic Approach 364 Accommodation and Tacit Collusion 365 The Milgrom-Roberts Model of Limit Pricing 367 Predation for Merger 374 Multimarket Reputation 376 The “Long Purse” Story 377 Concluding Remarks 380 Supplementary Section: Darwinian Selection in an Industry 3380 Answers and Hints 384 References 386 Research and Development and the Adoption of New Technologies 389 Incentives as a Function of the Market Structure: The Value of Innovation 390 Introduction to Patent Races 394 Welfare Analysis of Patent Protection 399 Alternative Inducements to R&D 400 10,5 Strategic Adoption of New Technologies 401 10.6 Network Externalities, Standardization, and Compatibility 404 10.7. Concluding Remarks 409 10.8 Supplementary Section: Patent Licensing and Research Joint Ventures 410 Answers and Hints 415 References 419 11 Noncooperative Game Theory: A User's Manual 423 11.1 Games and Strategies 423 112 Nash Equilibrium 425 11.3 Perfect Equilibrium 428 114 Bayesian Equilibrium 432 115 Perfect Bayesian Equilibrium 436 11.6 Supplementary Section 444 Answers and Hints 453 References 457 Contents Review Exercises 460 Index 473Preface Theoretical industrial organization has made substantial progress since the early 1970s, and has become a central element of the culture of microeconomics. This book is an attempt to give a straightforward account of the recent developments and to blend them into the tradition of industrial organization. For advice, encouragement, and criticism I am partic- ularly indebted to Philippe Aghion, Roland Beénabou, Patrick Bolton, Bernard Caillaud, Franklin Fisher, Paul Joskow, Bruno Jullien, Eric Maskin, Patrick Rey, Garth Saloner, Richard Schmalensee, and Michael Whinston, Dilip Abreu, Kyle Bagwell, John Bonin, Joel Demski, Peter Diamond, Drew Fudenberg, Robert Gertner, Robert Gibbons, Roger Guesnerie, Oliver Hart, Bengt Holmstrém, Jean-Jacques Laffont, Ariel Rubinstein, Stephen Salant, Steve Salop, Carl Shapiro, Andrea Shepard, Marius Schwartz, and Oliver Williamson offered yery useful com- ments on specific chapters. My debt to Paul Joskow and Richard Schmalensee— who encouraged me to undertake this endeavor, who read the entire manuscript, and who made pages and pages of critical comments—goes back to my days as a student at MIT. They are still teaching me about indus- trial organization. Former MIT students will recognize in the organization and in the choice of topics the influence of course 14.271, which Paul and Richard molded. My debt to Drew Fudenberg and Eric Maskin also goes back to my student days. While this debt extends well beyond the area of industrial organization, I must acknowledge that my vision of the game-theoretic aspects of industrial organization has been shaped by our ongoing collabora- tion. Eric taught me game theory and showed me how its tools could fruitfully be applied to various economic ques- tions. Drew’s input into this book is almost too obvious to be acknowledged. Part II and the Game Theory User's Manual borrow heavily from our joint research and sur- veys. David Kreps, Paul Milgrom, John Roberts, and Robert Wilson have also greatly influenced my views on strategic behaviors in markets, My intellectual debt ex-tends to fhe many fine researchers who have built the of Lausanne, as part of a basic graduate in industrial organization at MIT and at the Hautes Etudes en Sciences Sociales, and at ced-topics level at MIT. The students at those s supplied useful comments and expositional sequence Ecole de the adva institution suggestiq lam véry grateful to Benjamin Hermalin for his superb research dssistance. Not only did he read the entire manu- script and check the exercises; he also offered many in- sightful cbmments. | could not have been more fortunate in finding a research assistant, with respect to both dili- gence ang talent. I am also grateful to Bernice Soltysik for preparing the indexes and to Bruno Jullien for reading the proofs. | begah the writing of this baok while I was at the Ecole Nalfonale des Ponts et Chaussées. My 1983 ENSAE lecture nptes on industrial organization became Con- currence Iparfaite, published by Editions Economica in 1985. John and Héléne Bonin translated Concurrence Imparfaitd with competence and alacrity, enabling me to start building The Theory of Industrial Organization on the basis of that French-language version shortly after its gh this book is very much the outcome of a dertaking, none of those who contributed to it held responsible for any errors or omissions. [ to them for ignoring many of their good sug- group should b apologiz gestions |for completing and extending the exposition, My onls| excuse for not taking all their suggestions is that the hook might have doubled in size had | included them all.| I was fortunate to have as my editor Paul Bethge, who handled the manuscript with much intelligence, expe- rience, afd humor. I am also grateful to the rest of the very ablq team at The MIT Press—particularly to eco- nomics eflitor Terry Vaughn, for his help and encourage- ment, an| to designer Rebecca Daw, for a nice treatment of some faturally difficult material, Very {pecial thanks go to the skillful and multilingual Emily Ghllagher, who suffered through the typing of many drpfts, both in French and in English. With good xii cheer, she spent countless evenings and weekends so that the material could be ready for my students and then for publication. She did a beautiful job. The first French- language draft was typed by Patricia Maillebouis and Pierrette Vayssade. I gratefully acknowledge generous research grants from the National Science Foundation, the Sloan Foundation, the Center for Energy Policy Research at MIT, the MIT Fund for the Arts, Humanities, and Social Sciences, and the Commissariat Général au Plan. Jean Tirole Cambridge, Massachusetts Preface