. ECON 563 Managerial Economics Module 5: The Nature of Industry Copyright 2017 Montclair State University . ECON 563 Managerial Economics Module 5a: Brief Overview Learning Objectives (1) Calculate alternative measures of industry structure, conduct, and performance, and discuss their limitations. (2) Describe examples of vertical, horizontal, and conglomerate mergers, and explain the economic basis for each type of merger. (3) Explain the relevance of Herfindahl-Hirschman index for antitrust policy under the horizontal merger guidelines. Learning Objectives (4) Describe the structure-conduct-performance paradigm, the feedback critique, and their relation to the five forces framework. (5) Identify whether an industry is best described as perfectly competitive, a monopoly, monopolistically competitive, or an oligopoly. . ECON 563 Managerial Economics Module 5b: Market Structure Market Structure Market structure factors that impact managerial decisions : • Number of firms competing in an industry. • Relative size of firms (concentration). • Technological and cost conditions. • Demand conditions. • Ease of firm exit or entry. Industry Concentration Measures the size distribution of firms within an industry. • Are there many small firms ? • Are there only a few large firms ? Measures of Industry Concentration Measures the size distribution of firms within an industry. Four-firm concentration ratio : C4 = S1 + S2 + S3 + S4 . ST Herfindahl-Hirschman index (HHI) : HHI = 10000 ) N ( ∑ Si 2 i=1 ST . Si denote the output of firm i ranked from 1 (largest) to N (smallest) and ST being the industry aggregate output. Example Suppose an industry is composed of six firms. Four firms have sales of $20 each, and two firms have sales of $10 each. What is the four-firm concentration ratio for this industry ? Four-firm concentration ratio : ST = 20 × 4 + 10 × 2 = 100, S1 = S2 = S3 = S4 = 20, 80 C4 = = 0.80. 100 The four largest firms in the industry account for 80 percent of total industry output. . ECON 563 Managerial Economics Module 5c: C4 and HHI Data C4 and HHI for Selected US Industries Industry Breweries Distilleries Electronic Computers Fluid Milk Furniture and related products Jewelry (excluding costumes) Motor vehicles Ready-mix Concrete Source : Concentration Ratios 2007 US Bureau of the Census, 2012 C4 HHI 90 NA 70 1519 87 NA 46 1075 11 62 29 347 68 1744 23 313 C4 and HHI for Selected US Industries Industry Men's and Boys' cut and sewn apparel Semi-conductor & other elec. comp. Snack foods Soap and cleaning compound Soft drinks Women's and girls' cut and sewn apparel Source : Concentration Ratios 2007 US Bureau of the Census, 2012 C4 HHI 27 324 34 476 53 1984 47 848 52 891 20 174 Limitations of Concentration Measures Factors that impact and limit industry concentration measures include : • Global markets, • National, regional and local markets, • Industry definitions and product classes. . ECON 563 Managerial Economics Module 5d: Technology, Market Conditions Technology Industries differ in regard to the technologies used to produce goods and services. • Labor-intensive industries, • Capital-intensive industries. Within a given industry if the available technology is : • the same, firms will likely have similar cost structures, • different, one firm will likely have a cost advantage. Demand and Market Conditions Industries with • low demand may imply few firms. • high demand may imply many firms. Elasticity of demand varies from industry to industry. • The Rothschild index measures the sensitivity to price of a product group as a whole relative to the sensitivity of the quantity demanded of a single firm to a change in its price. • R = EET . F Example The industry elasticity of demand for airline travel is -4. The elasticity of demand for an individual carrier is -5. What is the Rothschild index for this industry ? Rothschild index = −4 = 0.80. −5 Rothschild Index Industry Food Tobacco Textiles Apparel Paper eT -1.0 -1.3 -1.5 -1.1 -1.5 eT -3.8 -1.3 -4.7 -4.1 -1.7 R 0.26 1.00 0.32 0.27 0.88 Source : Mathew D Shapiro "Measuring Market Power in US Industry", NBER WP No. 2212, 1987 Rothschild Index Industry Printing & publishing Chemicals Petroleum Rubber Leather eT -1.8 -1.5 -1.5 -1.8 -1.2 eT -3.2 -1.5 -1.7 -2.3 -2.3 R 0.56 1.00 0.88 0.78 0.52 Source : Mathew D Shapiro "Measuring Market Power in US Industry", NBER WP No. 2212, 1987 . ECON 563 Managerial Economics Module 5e: Entry, Market Power Potential for Entry Optimal decisions by firms in an industry will depend on the ease with which new firms can enter the market. Several factors can create barriers to entry (or make entry difficult). • Capital requirements, • Patents, • Economies of scale. Lerner Index A measure of the difference between price and marginal cost as a fraction of the product's price. L= P − MC . P ( ) 1 Rearranging this equation yields P = 1−L M C, where ( ) 1 1−L is the markup factor over marginal costs. Example A firm in the airline industry has a marginal cost of $400 and charges a price of $600. The Lerner index is L= P − MC 600 − 400 1 = = . P 600 3 The markup factor is ( Markup factor = 1 1−L ) ( = 1 1− ) 1 3 = 1.5 Lerner Index and Markup Factor Data Industry Lerner Index Markup Food 0.26 1.35 Tobacco 0.76 4.17 Textiles 0.21 1.27 Apparel 0.24 1.32 Paper 0.58 2.38 Source : Michael R Baye and Jay-Woo Lee (1990) ; Mathew D Shapiro (1987) Lerner Index and Markup Factor Data Industry Lerner Index Markup Printing & publishing 0.31 1.45 Chemicals 0.67 3.03 Petroleum 0.59 2.44 Rubber 0.43 1.75 Leather 0.43 1.75 Source : Michael R Baye and Jay-Woo Lee (1990) ; Mathew D Shapiro (1987) . ECON 563 Managerial Economics Module 5f: Integration and Other Factors Integration and Merger Integration • Uniting productive resources of firms. • Can occur during the formation of a firm. Merger • Two or more existing firms "unite", or merge, into a single firm. Reasons for Merger • Reduce transaction costs. • Reap benefits of economies of scale and scope. • Increase market power. • Gain better access to capital markets. Types of Integration Vertical integration • Various stages in the production of a single product are carried out in a single firm. Horizontal integration • Merging two or more similar final products into a single firm. Conglomerate mergers • Integration of two or more different product lines into a single firm. Research and Development Expenditures made by firms (as % of sales) to gain a technological advantage, with the aim of acquiring a patent. Firm Industry R&D Bristol-Meyers Squibb Pharmaceuticals 19.7 Ford Motor vehicle 4.1 Goodyear Tires 2.0 Kellogg Food 1.5 Proctor & Gamble Cosmetics 2.5 Advertisement Expenditures made by firms (as % of sales) to inform or persuade consumers to purchase their products. Firm Industry Advt Bristol-Meyers Squibb Pharmaceuticals 4.9 Ford Motor vehicle 3.2 Goodyear Tires 2.6 Kellogg Food 9.2 Proctor & Gamble Cosmetics 11.7 Performance Refers to the profits and social welfare that result in a given industry • Dansby-Willig Performance Index • Ranks industries according to how much social welfare would improve if the output in an industry were increased by a small amount. Dansby-Willig Performance Index Industry Dansby-Willig Index Food 0.51 Chemicals 0.67 Petroleum 0.63 Rubber 0.49 Textiles 0.38 . ECON 563 Managerial Economics Module 5g: SCP Paradigm Structure Conduct Performance Structure : • Factors like technology, concentration and market conditions. Conduct : • Individual firm behavior in the market. Behavior includes pricing decisions, advertising decisions and R&D decisions, among other factors. SCP Paradigm Performance : • Resulting profit and social welfare that arise in the market. Structure-conduct-performance paradigm : • Model that views these three aspects of industry as being integrally related. The Casual View • Market structure “causes” firms to behave in a certain way. • … this behavior, or conduct, “causes” resources to be allocated in certain ways. • … this resource allocation leads to “good” or “bad” performance. The Feedback Critique • There is no one-way causal link among structure, conduct and performance. • Firm conduct can affect market structure. • Market performance can affect conduct and market structure. . ECON 563 Managerial Economics Module 6: Competitive and Monopolistic Markets Copyright 2017 Montclair State University . ECON 563 Managerial Economics Module 6a: Brief Overview Learning Objectives (1) Identify the conditions under which a firm operates as perfectly competitive, monopolistically competitive, or a monopoly. (2) Identify sources of (and strategies for obtaining) monopoly power. (3) Apply the marginal principle to determine the profit maximizing price and output. (4) Show the relationship between the elasticity of demand for a firm’s product and its marginal revenue. Learning Objectives (5) Explain how long-run adjustments impact perfectly competitive, monopoly, and monopolistically competitive firms. (6) Discuss the ramifications of each of these market structures on social welfare. (7) Decide whether a firm making short-run losses should continue to operate or shut down its operations. Learning Objectives (8) Illustrate the relationship between marginal cost, a competitive firm’s short-run supply curve, and the competitive industry supply. (9) Explain why supply curves do not exist for firms that have market power. (10) Calculate the optimal output of a firm that operates two plants and the optimal level of advertising for a firm that enjoys market power. . ECON 563 Managerial Economics Module 6b: Perfectly Competitive Industry Perfect Competition Perfectly competitive markets are characterized by : • The interaction between many buyers and sellers that are “small” relative to the market. • Each firm in the market produces a homogeneous (identical) product. • Buyers and sellers have perfect information. • No transaction costs. • Free entry into and exit from the market. Perfect Competition The implications of these conditions are : • A single market price is determined by the interaction of demand and supply. • Firms earn zero economic profits in the long run. P Market demand in perfect competition S P� D 0 Q P P� 0 Firm demand is perfectly elastic at P � Df = P � q . ECON 563 Managerial Economics Module 6c: Profit Maximization Short-run Production Decision Market structure factors that impact managerial decisions : • The short run is a period of time over which some factors of production are fixed. • To maximize short-run profits, managers must take as given the fixed inputs (and fixed costs), and determine how much output to produce by changing the variable inputs. $ Maximum Profit � occurs at output q � TC TR � 0 q� q Competitive Firm's Demand As we have seen in an earlier slide, the demand curve for a competitive firm’s product is a horizontal line at the market price. This price is the competitive firm's marginal revenue. Df = P = M R. Competitive Output Rule To maximize profits, a perfectly competitive firm produces the output at which price equals marginal cost in the range over which marginal cost is increasing. P = M C(q). Example The cost function for a firm is C(q) = 5 + q 2 . • If the firm sells output in a perfectly competitive market and other firms in the industry sell output at a price of $20, what price should the manager of this firm charge ? The firm should sell output at the market price P � = 20. • What level of output should be produced to maximize profits ? P = M C(q) = 2q - 20 = 2q, or q � = 10. • How much profit will be earned ? � = P q � − T C(q � ) = 20 × 10 − 5 − 102 = 95. Short-Run Output Decision • To maximize short-run profits, a perfectly competitive firm should produce in the range of increasing marginal cost where P = M C, provided that P � AV C. • If P < AV C, the firm should shut down its plant to minimize it losses. Short-Run Firm and Industry Supply Curves The short-run supply curve for a perfectly competitive firm is its marginal cost curve above the minimum point on the AV C curve. The Market Supply Curve P M Ci Market Supply 9 0 1 500 Q Long-Run Competitive Equilibrium In the long run, perfectly competitive firms produce a level of output such that P = M C, and P = minimum of AC. . ECON 563 Managerial Economics Module 6d: Monopoly Monopoly and Monopoly Power Monopoly : • A market structure in which a single firm serves an entire market for a good that has no close substitutes. • Sole seller of a good in a market gives that firm greater market power than if it competed against other firms. Implication : • Market demand curve is the monopolist’s demand curve. • However, a monopolist does not have unlimited market power. P Monopolist power constrained by demand P0 Df = DM P1 0 Q0 Q1 Q Sources of Monopoly Power • Economies of scale : exist whenever long-run average costs decline as output increases. • Diseconomies of scale : exist whenever long-run average costs increase as output increases - Not a source of monopoly power. • Economies of scope : exist when the total cost of producing two products within the same firm is lower than when the products are produced by separate firms. Sources of Monopoly Power • Cost complementarity : exist when the marginal cost of producing one output is reduced when the output of another product is increased. • Patents and other legal barriers. P Elasticity of Demand and Marginal Revenue 100 Elastic Unit Elastic Inelastic 0 50 100 Q TR Elasticity of Demand and Total Revenue Unit Elastic 2500 Elastic 0 Inelastic 50 100 Q Marginal Revenue and Elasticity The monopolist’s marginal revenue function is ( ) 1+c MR = P, c where c is the elasticity of demand for the monopolist’s product and P is the price charged. For P > 0, • M R > 0 when c < −1. • M R = 0 when c = −1. • M R < 0 when −1 < c < 0. . ECON 563 Managerial Economics Module 6e: Monopoly Profit with Linear Demand Linear Demand and Marginal Revenue Given a linear inverse demand function P (Q) = a − bQ, where a > 0 and b > 0, the associated marginal revenue is M R(Q) = a − 2bQ. An Example Suppose the inverse demand function for a monopolist’s product is given by P (Q) = 100 − 2Q, What is the maximum price per unit a monopolist can charge to be able to sell 30 units ? P (30) = 100 − 2(30) = $40. What is marginal revenue when Q = 30 ? M R(30) = 100 − 2(2)(30) = −$20. Monopoly Output Rule A profit-maximizing monopolist should produce the output, QM , such that marginal revenue equals marginal cost : ( ) ( ) M R QM = M C QM . An Example of Monopoly Profit Suppose the inverse demand function for a monopolist’s product is given by P = 100 − 2Q and the cost function is C(Q) = 100 + 20Q. Note M C(Q) = 20. • Profit-maximizing output is found by solving : M R = 100 − 4Q = 20 = M C, 4Q = 80 - QM = 20. • The profit-maximizing price is : P M = 100 − 2 × QM = 100 − 2 × 20 = 60. • Maximum profit is M = T R − T C = 60(20) − 100 − 20(20) = $700. Absence of a Supply Curve • Firms operating in perfectly competitive markets deter- mine how much output to produce based on price (P = M C) • Thus, a supply curve exists in perfectly competitive markets. • A monopolist’s market power implies P > M R = M C. • Thus, there is no supply curve for a monopolist, or in markets served by firms with market power. . ECON 563 Managerial Economics Module 6f: Multi-plant Decision Rules Multi-plant Decisions • Often a monopolist produces output in different loca- tions. • Implications : manager has to determine how much output to produce at each plant. Multi-plant Decisions • Consider a monopolist producing output at two plants. • The cost of producing Q1 units at plant 1 is C1 (Q1 ), and the cost of producing Q2 units at plant 2 is C2 (Q2 ). • When the monopolist produces a homogeneous product, the per-unit price consumers are willing to pay for the total output produced at the two plants is P (Q), where Q = Q1 + Q2 . Multi-plant Decisions • Let M R(Q) be the marginal revenue of producing a total of Q = Q1 + Q2 units of output. • Suppose the marginal cost of producing Q1 units of output in plant 1 is M C1 (Q1 ) and that of producing Q2 units in plant 2 is M C2 (Q2 ). • The profit-maximizing rule for the two-plant monopolist is to allocate output among the two plants such that : M R(Q) = M C1 (Q1 ) = M C2 (Q2 ). Implications of Entry Barriers • A monopolist may earn positive economic profits, which in the presence of barriers to entry prevents other firms from entering the market to reap a portion of those profits. • Implication : monopoly profits will continue over time provided the monopoly maintains its market power. • Monopoly power, however, does not guarantee positive profits. Deadweight Loss of Monopoly The consumer and producer surplus that is lost due to the monopolist charging a price in excess of marginal cost. P Shaded area is dead weight loss of social welfare MC 0 QM QC Q . ECON 563 Managerial Economics Module 6g: Monopolistic Competition Monopolistic Competition An industry is monopolistically competitive if : • There are many buyers and sellers. • Each firm in the industry produces a differentiated product. • There is free entry into and exit from the industry. Monopolistic Competition • A key difference between monopolistically competitive and perfectly competitive markets is that each firm produces a slightly differentiated product. • Implication : products are close, but not perfect, substitutes. • Therefore, firm’s demand curve is downward sloping under monopolistic competition. Profit-Maximization Rule for Monopolistic Competition • To maximize profits, a monopolistically competitive firm produces Q� where its marginal revenue equals marginal cost. • The profit-maximizing price is the maximum price per unit that consumers are willing to pay for the output Q� . • The profit-maximizing output, Q� , is such that M R(Q� ) = M C(Q� ) and the profit-maximizing price is P � = P (Q� ). Long-Run Equilibrium If firms in monopolistically competitive markets earn shortrun • profits, additional firms will enter in the long run to capture some of those profits. • losses, some firms will exit the industry in the long run. Long-Run Equilibrium In the long run, monopolistically competitive firms produce a level of output such that : P > M C, and P = AT C > Minimum of average cost. The differentiated nature of products in monopolistically competitive markets implies that firms in these industries must continually convince consumers that their products are better than their competitors. . ECON 563 Managerial Economics Module 7: Oligopolistic Markets Copyright 2017 Montclair State University . ECON 563 Managerial Economics Module 7a: Brief Overview Learning Objectives (1) Explain how beliefs and strategic interaction shape optimal decisions in oligopoly environments. (2) Identify the conditions under which a firm operates in a Sweezy, Cournot, Stackelberg, or Bertrand oligopoly. (3) Explain the ramifications of each type of oligopoly for optimal pricing decisions, and firm profits. Learning Objectives (4) Apply reaction (or best-response) functions to identify optimal decisions and likely competitor responses in oligopoly settings. (5) Identify the conditions for a contestable market, and explain the ramifications for market power and the sustainability of long-run profits. . ECON 563 Managerial Economics Module 7b: Oligopoly Features Conditions for Oligopoly Oligopoly market structures are characterized by only a few firms, each of which is large relative to the total industry. • Typical number of firms is between 2 and 10. • Products can be identical or differentiated. Conditions for Oligopoly An oligopoly market composed of two firms is called a duopoly. • Oligopoly settings tend to be the most difficult to manage since managers must consider the likely impact of his or her decisions on the decisions of other firms in the market. Sweezy Oligopoly : Characteristics • There are few firms in the market serving many consu- mers. • The firms produce differentiated products. • Each firm believes its rivals will cut their prices in response to a price reduction but will not raise their prices in response to a price increase. • Barriers to entry exist. . ECON 563 Managerial Economics Module 7c: Cournot Oligopoly Cournot Oligopoly : Characteristics • There are few firms in the market serving many consu- mers. • The firms produce either differentiated or homogeneous products. • Each firm believes rivals will hold their output constant if it changes its output. • Barriers to entry exist. Cournot Oligopoly : Reaction Functions Consider a Cournot duopoly. • Each firm makes an output decision under the belief that its rival will hold its output constant when the firm itself changes its output level. • Implication : Each firm’s marginal revenue is impacted by the other firms output decision. • The relationship between each firm’s profit-maximizing output level is called a best-response or reaction function. An Example of Reaction Function Given a linear (inverse) demand function, P = a − b(Q1 + Q2 ) and cost functions, C1 (Q1 ) = c1 Q1 and C2 (Q2 ) = c2 Q2 , the reaction functions are Q1 = r1 (Q2 ) = a − c1 Q2 − , and 2b 2 Q2 = r2 (Q1 ) = a − c2 Q1 − . 2b 2 Q2 Cournot Reaction Functions QM 2 Q�2 0 Q�1 QM 1 Q1 Cournot Oligopoly : Equilibrium A situation in which neither firm has an incentive to change its output given the other firm’s output. Cournot Oligopoly : Collusion • Markets with only a few dominant firms can coordinate • • • • to restrict output to their benefit at the expense of consumers. Restricted output leads to higher market prices. Such acts by firms is known as collusion. Collusion, however, is prone to cheating behavior. Since both parties are aware of these incentives, reaching collusive agreements is often very difficult. . ECON 563 Managerial Economics Module 7d: Stackelberg Oligopoly Stackelberg Oligopoly : Characteristics • There are few firms in the market serving many consu• • • • mers. The firms produce either differentiated or homogeneous products. A single firm (the leader) chooses an output before all other firms choose their outputs. All other firms (the followers) take as given the output of the leader and choose outputs that maximize profits given the leader’s output. Barriers to entry exist. An Example of Reaction Function Given a linear (inverse) demand function, P = a − b(Q1 + Q2 ) and cost functions, C1 (Q1 ) = c1 Q1 and C2 (Q2 ) = c2 Q2 , the follower sets output according to the reaction function Q2 = r2 (Q1 ) = a − c2 Q1 − . 2b 2 and the leader’s output is Q1 = a + c2 − 2c1 . 2b An Example • Suppose the inverse demand function for two firms in a homogeneous-product, Stackelberg oligopoly is given by P = 100 − Q1 − Q2 and their costs are zero. • Firm 1 is the leader, and firm 2 is the follower. • In this example, a = 100, b = 1, c1 = c2 = 0. • Firm 2's reaction function : Q2 = a − c2 Q1 100 Q1 − = − = 50 − 0.5Q1 . 2b 2 2 2 An Example • Firm 1’s output : Q1 = a + c2 − 2c1 100 + 0 − 2(0) = = 50. 2b 2 • Firm 2’s output : Q2 = 50 − 0.5Q1 = 50 − 0.5(50) = 25. • The market price : P = 100 − (Q1 + Q2 ) = 100 − 50 − 25 = 25. . ECON 563 Managerial Economics Module 7e: Bertrand Oligopoly Bertrand Oligopoly : Characteristics • There are few firms in the market serving many consu• • • • mers. Firms produce identical products at a constant marginal cost. Firms engage in price competition and react optimally to prices charged by competitors. Consumers have perfect information and there are no transaction costs. Barriers to entry exist. Bertrand Oligopoly : Equilibrium • The conditions for a Bertrand oligopoly imply that firms in this market will undercut one another to capture the entire market leaving the rivals with no profit. • All consumers will purchase at the low-price firm. • This “price war” would come to an end when the price each firm charged equaled marginal cost. • In equilibrium, P1 = P2 = M C and the socially efficient level of output is sold. . ECON 563 Managerial Economics Module 7f: Oligopoly Example An Example to Compare Oligopoly Models • Suppose the inverse demand function for two firms in a homogeneous-product oligopoly is given by P = 100 − Q1 −Q2 and the cost function for each firm in this market is identical, and given by Ci (Qi ) = 4Qi . • Under these condition, the different oligopoly outputs, prices and profits are examined. • In this example, a = 100, b = 1, c1 = c2 = 4. An Example to Compare Oligopoly Models • The Cournot oligopoly reaction functions are : Q2 = a − c2 Q1 100 − 4 Q1 − = − = 48 − 0.5Q1 , 2b 2 2 2 Q1 = 48 − 0.5Q2 • These reaction functions can be solved for the equili- brium output. Q2 = 48 − 0.5Q1 = 48 − 0.5(48 − 0.5Q2 ) = 24 − 0.25Q2 . An Example to Compare Oligopoly Models • This implies Q2 = 32, Q1 = Q2 = 32 and Q = 64. • Then P = 100−64 = 36 and 11 = 12 = 32×36−32×4 = 32 × 32 = 1024. Comparing Oligopoly : Stackelberg • The Stackelberg leader's output is Q1 = a + c2 − 2c1 100 + 4 − 2(4) = = 48. 2b 2 • Firm 2's output is Q2 = 100 − 4 Q1 a − c2 Q1 − = − = 48 − 0.5(48) = 24. 2b 2 2 2 Comparing Oligopoly : Stackelberg • The market price : P = 100 − (Q1 + Q2 ) = 100 − 48 − 24 = 28. • The profits are 11 = 48 × 28 − 48 × 4 = 48 × 24 = 1152, 12 = 24 × 28 − 24 × 4 = 576. Comparing Oligopoly : Bertrand • Since P = M C, P = 4. Total output is Q = 100 − 4 = 96. • Given symmetric firms, each firm gets half the market, or 48 units. • The profits are 11 = 12 = 0. Comparing Oligopoly : Collusion • Since the output associated with collusion is the same as monopoly output, the inverse market demand function implies that monopoly marginal revenue function is : M R = 100 − 2Q. • Setting marginal revenue equal to marginal cost yields : 100 − 2Q = 4 - Q = 48. Comparing Oligopoly : Collusion • Each firm will produce half of these units, Q1 = Q2 = 24. • Price P = 100 − 48 = 52. • The profits are 11 = 12 = 52 × 24 − 4 × 24 = 48 × 24 = 1152. Contestable Markets They involve strategic interaction among existing firms and potential entrants into a market. A market is contestable if : • All producers have access to the same technology. • Consumers respond quickly to price changes. • Existing firms cannot respond quickly to entry by lowering price. • There are no sunk costs. • If these conditions hold, incumbent firms have no market power over consumers.
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