Market Structure

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Competition, market structures and

business decisions

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What is the market Structure What is the market Structure

Competition, market structures and business decisions

Competition, market structures and business decisions

How does competition affect business decisions in different

market structures?

How does competition affect business decisions in different

market structures?

Perfect competition; monopoly; oligopoly; monopolistic

competition

Perfect competition; monopoly; oligopoly; monopolistic

competition

Competitive strategies. Competitive strategies.

Measurement of market structures Measurement of market structures

Market strategies in different market structures.

Market strategies in different market structures.

Non-price competition.Non-price competition.

Multinational companies. Vertical and horizontal coordination.

Multinational companies. Vertical and horizontal coordination.

Learning objectives Learning objectives

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Market structures Market structures

What is the market structure?

The competitive environment in the market for any product is the market structure faced by the firm

– Is measured in terms of the number of the actual buyers and sellers plus potential

entrants Barriers to entry and exit Capital requirements Price vs Non-price competition Etc

– Potential entrants pose a sufficiently credible threat of entry to affect price/output decisions of incumbents

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Factors that Shape the Competitive Environment

Product Differentiation– R&D, innovation, and advertising are important in many

markets. Production Methods

– Economies of scale can preclude small-firm size. Entry and Exit Conditions

– Barriers to entry and exit can shelter incumbents from potential entrants.

Buyer Power– Powerful buyers can limit seller power.


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Perfect competition

Perfect competition

OligopolyOligopoly

The firm in competitive marketsThe firm in competitive markets

MonopolyMonopoly

Non-perfect competitionNon-perfect competition

Monopolistic competition

Monopolistic competition

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Market structures Market structures “Perfect competition” – competitive markets

Profit maximiser Identical product Very small share of the market Price-taker Produces a homogeneous product Perfect information No barriers to entry (legal, technological, or

resource) No technical progress No investment lag - Immediate implementation of

production decisions) Homogeneous goals of the owners and

managerial staff

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Examples of Competitive Markets– Agricultural commodities.– Some prominent markets for intermediate goods and

services.– Unskilled labor market.


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Profit Maximization Imperative– Normal profit is return necessary to attract and maintain

capital investment.– Efficient firms can earn normal profit.– Inefficient firms suffer losses.

Role of Marginal Analysis– Set Mπ = MR – MC = 0 to maximize profits.– MR=MC when profits are maximized.


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Marginal Cost and Firm Supply

Short-run Firm Supply– Competitive market price

(P) is shown as a horizontal line because P=MR.

– Firm’s marginal-cost curve shows the amount of output the firm would be willing to supply at any market price.

– Marginal cost curve is the short-run supply curve so long as P > AVC .

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Long-run Firm Supply

Marginal cost curve is the long-run supply curve so long as P > ATC.

In long run, firm must cover all necessary costs of production and earn a normal profit.


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Long Run Normal Profit Equilibrium

With a horizontal market demand curve, MR=P.

P=MR=MC=ATC.

There are no economic profits.

All firms earn a normal rate of return.

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Price, cost

Competition, market structures and business decisionsCompetition, market structures and business decisions

Market structures Market structures Perfect competition

Breakeven point

Output per time period

MC

ATC

AVC

0

D

B

per unit

Qoff peak

Q peak

Poff peak

Ppeak

Poff peak – break even price off peak. At this price the firm expects to return only variable costs and can produce quantity Qoff peak

Ppeak- break even price at peak. This is when the firm expects to return both fixed and variable costs

producing quantity Qpeak

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Competitive Market Supply Curve

Market Supply With a Fixed Number of Competitors

Supply is the sum of competitor output.

Market Supply With Entry and Exit

Entry results in more firms, increased output, a rightward shift in the supply curve, and drives down prices and profits.

Exit reduces the number of firms, decreases the quantity of output, shifts the supply curve leftward, and allows prices and profits to rise for remaining competitors.



14Quantity per time period (millions)

10

8

6

4

2

0

Supply

50 100150200250300350400

Price per unit ($)

P = – $0.254 + $0.000025

Q

P = $40 – $0.0001Q

Demand


Market structures Market structures Perfect competition

Market price determination

Negatively sloped demand curve

Positively sloped supply curve

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Market structures Market structures Monopoly

Basic Properties

One firm in industry Profit-maximiser Faces market demand curve One product No close substitutes Price-maker No restrictions on resources Blockaded entry and/or exit Imperfect dissemination of information Opportunity for economic profits in long-run equilibrium.

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Examples of Monopoly– Electricity utilities, – Gas – Water– Public Tramsport– Telecommunications



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Profit Maximization in Monopoly Markets

Price/Output Decisions A monopoly firm is the

market. Market and firm demand

curve slopes downward. Monopoly demand curve is

always above the marginal revenue curve, P = AR > MR.

Monopoly position allows above-normal profits.P > AC in long-run

equilibrium. Set Mπ = MR - MC = 0 to

maximize profits. MR=MC at optimal output.

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Social Costs of Monopoly Monopoly Underproduction

Monopolists produce too little output.

Monopolists charge prices that are too high.

Deadweight Loss from MonopolyMonopoly markets creates a

loss in social welfare due to the decline in mutually beneficial trade activity.

There is also a wealth transfer problem associated with monopoly.

Under monopoly, consumer surplus is transferred to producer surplus.

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Social Benefits From Monopoly

Economies of ScaleMonopoly is sometimes the natural result of vigorous competitive

forces.In natural monopoly, LRAC declines continuously and one firm is

most efficient.Some real-world monopolies are government-created or government-

maintained. Invention and Innovation

Public policy sometimes confers explicit monopoly rights to spur productivity.



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Monopoly Regulation

Dilemma of Natural MonopolyMonopoly has the potential for efficiency.Unregulated monopoly can lead to economic profits and

underproduction.

ECW3830 COMPETITION AND REGULATION



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Market structures Market structures In the “real life”

• A typical firm, if it is not a small one, is not owner-managed

• Separation of ownership, long-term strategic and short-run current control (shareholders, board of directors, brunch managers) implies the segregation of objectives;

• Natural, economic and legal barriers

• Diversification (non-homogenous product, more than one kind of activity)

• Technical progress

• Different criteria for different time horizons (short-run operation vs long-run planning.

• Price-making

• Price/marketing strategies

• Imperfect information

• Investment lag

A “real” firm in a market place (compare to the “ideal” one):

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Contrast Between Monopolistic Competition and Oligopoly

Monopolistic Competition

• Large number of sellers that offer differentiated products.

• Normal profit opportunity in long-run equilibrium. Oligopoly

• Few sellers.

• Economic profits are possible in long-run equilibrium. Dynamic Nature of Competition

• Timely market structure information is required for managerial investment decisions


Market structures Market structures Oligopoly and Monopolistic Competition

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Market structures Market structures Мonopolistic competition

• The market consists of n mono-product firms;

• The products are viewed by the buyers as close though not perfect substitutes for one another;

• Therefore, each of the sellers is a monopolist of its particular product variant with a limited degree of monopoly power.

• Such a monopolist is enjoying a monopoly power and making economic profit during only a short period of time

• from the introduction of an unique product or technology

• until such a technology becomes available to rivals, or

• until a new “more innovative” product is introduced by a rival.

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Q

Short-run Monopoly EquilibriumMonopolistically competitive firms take full advantage of short-run monopoly.



Price

Costs

Quantity

MR Demand

MCAC

Qmc

Pmc

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Long-run equilibrium same costs, lower demand and excess capacity – low output high price decision

With differentiated products, P=AC at a point above minimum LRAC.P > MR = MC.



Price

Costs

QuantityMR1

D1

MC AC

MR2

D2

Price

Costs

Quantity

MC AC

Pmc

Qmc

MRD

Entry of new firms offering product substitutes shifts the demand and MR curves)

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Long-run equilibrium– high output low price decision (corresponds to perfect Competition) With homogenous products, P=AC at minimum LRAC.

This is a competitive market equilibrium with homogeneous production.



Price

Costs

QuantityMR1

D1

MC AC

MR2

D2

Price

Costs

Quantity

MC AC

Pmc

Qmc

MRD

Qac

Pac

Long-run equilibrium same costs, lower demand and excess capacity – low output high price decision

With differentiated products, P=AC at a point above minimum LRAC.P > MR = MC.

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Oligopoly Market Characteristics

• Few sellers.

• Homogenous or unique products.

• Blockaded entry and exit.

• Imperfect dissemination of information.

• Opportunity for above-normal (economic) profits in long-run equilibrium.

Examples of Oligopoly

• National markets for aluminum, cigarettes, electrical equipment, filmed entertainment, ready-to-eat cereals, etc.

• Local retail markets for gasoline, food, specialized services, etc.


Market structures Market structures Oligipoly

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Cartels and Collusion

Overt and Covert Agreements

• Cartels operate under formal agreements.

Powerful cartels function as a monopoly.

• Collusion exists when firms reach secret, covert agreements. Enforcement Problem

• Cartels are typically rather short-lived because coordination problems often lead to cheating.

• Cartel subversion can be extremely profitable.

• Detecting the source of secret price concessions can be extremely difficult.



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Cartels and Collusion

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Oligopoly Output-Setting Models

Cournot Oligopoly Cournot equilibrium

output is found by simultaneously solving output-reaction curves for both competitors.

Cournot equilibrium output exceeds monopoly output but is less than competitive output.

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Stackelberg Oligopoly

• Stackelberg model posits a first-mover advantage.

• Price wars severely undermine profitability for both leading and following firms.

• Price signaling can reduce uncertainty in oligopoly markets.

• Price leadership occurs when firms follow the industry leader’s pricing policy.

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Stackelberg Oligopoly

• Price leader sets the price at P2

• Profit is maximised at Q1.

• The follower(s) will supply the combined output of Q4-Q1

• At P3- Follows will supply everything

At P1 – the leader will supply everything at no economic profit

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Oligopoly Price-Setting Models

Bertrand Oligopoly: Identical Products

– The Bertrand model focuses upon the price reactions.

– The Bertrand model predicts a competitive market price/output solution in oligopoly markets with identical products.

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Oligopoly Price-Setting Models

Bertrand Oligopoly: Identical Products

– The Bertrand model focuses upon the price reactions.

– The Bertrand model predicts a competitive market price/output solution in oligopoly markets with identical products.

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Types of Games– Zero-sum game: offsetting gains/losses.– Positive sum game: potential for mutual gain.– Negative-sum game: potential for mutual loss.– Cooperative games: joint action is favored.

Role of Interdependence– Sequential games: moves in succession. – Simultaneous-move game: coincident moves.

Strategic Considerations


Market structures Market structures Game Theory Basics

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Prisoner’s Dilemma

Classic Riddle– Rational behavior can give suboptimal result.– Rationality can hamper beneficial cooperation.

Business Application– Dominant strategy gives best result regardless of moves by

other players. – Secure strategy gives best result assuming the worst

possible scenario. Broad Implications



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Nash Equilibrium

Nash Equilibrium Concept– Neither player can improve their payoff through a unilateral

change in strategy.– Nash equilibrium concept is broader than the concept of a

dominant strategy equilibrium.– Every dominant strategy equilibrium is also a Nash

equilibrium.– Nash equilibrium can exist where there is no dominant

strategy equilibrium. Nash Bargaining



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Infinitely Repeated Games

Role of Reputation– Infinitely repeated games occur over and over again without

boundary or limit.– Firms receive sequential payoffs that shape current and

future strategies.– Reputations for high quality give consumers confidence for

repeat transactions. Product Quality Games

– In a one-shot game, poor quality can fool customers.– In an infinitely repeated game, poor quality is shunned by

customers.



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Finitely Repeated Games

Uncertain Final Period– Finitely repeated games have limited duration. – With end point uncertainty, a finitely repeated game mirrors

an infinitely repeated game. End-of-game Problem

– Enforcing end-of-game performance is difficult.– Solution: simply extend the game!

First-mover Advantages– Benefits earned by the player able to make the initial move in

a sequential move or multistage game.



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Competitive strategies in Imperfectly competitive markets


Not all industries offer the same potential for sustained profitability;

Not all firms are equally capable of exploring the profit potential that is available.

An effective competitive strategy in imperfectly competitive markets must be founded on the firms competitive advantage.

Not all industries offer the same potential for sustained profitability;

Not all firms are equally capable of exploring the profit potential that is available.

An effective competitive strategy in imperfectly competitive markets must be founded on the firms competitive advantage.

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A competitive advantage is a unique or rare ability to create, distribute or service valued by customers.

It is a business-world analogue to what economists call comparative advantage or when one nation or region of the country is better suited to the production of one product than to the production of some other product

Above-normal rate of return require a competitive advantage that cannot easily be copied

In production;

In distribution; or

In marketing

A competitive advantage is a unique or rare ability to create, distribute or service valued by customers.

It is a business-world analogue to what economists call comparative advantage or when one nation or region of the country is better suited to the production of one product than to the production of some other product

Above-normal rate of return require a competitive advantage that cannot easily be copied

In production;

In distribution; or

In marketing

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Reasons for competitive advantage: Access to a unique resource

(Exclusive) Access to a mineral deposit

(Exclusive) Access to a material Efficient energy source Unique climatic condition Unique technology Unique (specially qualified or very talented) labour

force; or Access to a unique market

A university bookshop The rice market in Japan etc

Reasons for competitive advantage: Access to a unique resource

(Exclusive) Access to a mineral deposit

(Exclusive) Access to a material Efficient energy source Unique climatic condition Unique technology Unique (specially qualified or very talented) labour

force; or Access to a unique market

A university bookshop The rice market in Japan etc

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Product differentiationProduct differentiation

Product differentiation refers to the increase in time of the number of

product categories suppled and the number of items in each category

Product differentiation refers to the increase in time of the number of

product categories suppled and the number of items in each category

Historically, a step from oligopolistic to monopolistic competition

Historically, a step from oligopolistic to monopolistic competition

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Product differentiationProduct differentiation

A simple model of the reason for product differentiation

Price

QuantityQ

P

P*

• Considers constant quantity as well as non-changing AC and MC corresponding to this quantity

• Producing a little bit different product a firm might hope to charge a higher price

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Barriers to entryBarriers to entry

Price

QuantityQ

P

P*

LAC

LAC*

Absolute cost advantages:

Ability of established firms to produce any given level of outputat lower unit costs than potentialentrants

Q*

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Price

QuantityQ*

P

Economies of scale:

Ability of established firms

* To produce any given level of outputgreater than a certain level Q* at lower unit costs and * To restrict potential entrants who are not able to invest in that level of production

D

LAC




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Price

QuantityQ*

P*

Product differentiation advantages:

Variety of demand curvesand common LAC.

Some firms have advantage of technology or specialisation and are facing demand curves to the right of the critical one.

D1

LAC

D2D2




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Appear as the result of

• Ability to affect prices and

• Separation of ownership and managerial control

Appear as the result of

• Ability to affect prices and

• Separation of ownership and managerial control

* Managers’ aim at stability and increase in salaries*Stability may be achieved through the increase in the scale of operations*Increase in sales (not in profit) affects manager’s remuneration* Banks and retailers would prefer to deal with firms increasing the volume of sales


Non-profit-maximising competition.Non-profit-maximising competition.

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DMR

AC

MC

Q

P, Cost

Profit maximisingdecision


Non-profit-maximising competition.


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DMR

Q

P, Cost


Salesmaximisingdecision

Increasing sales, the firm is moving to the right and downward the demand curve and, therefore, decreases price,

The limitation is AC curve. Some profit should be earned anyway




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DMR

AC

MC

Q

P, Cost





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Old sales maximising decision is a profitmaximising decision at a new level of average cost

Old profit maximisingdecision

New profit maximisingdecision

DMR

AC

MC

Q

P, Cost




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Seller concentrationSeller concentration

Seller concentration refers to the degree to which production for a particular market or or in a particular industry is concentrated in the hand of few large firms

Seller concentration refers to the degree to which production for a particular market or or in a particular industry is concentrated in the hand of few large firms

• number of firms in the market

• size distribution of firms in the market

Measurement of concentration

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The Australian Bureau of Statistics

8140.0.55.001 Industry Concentration Statistics

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C2542 - Paint Manufacturing in Australia KEY COMPETITORS (www.ibisworld.com.au/static/iwabout/SamIndPart.asp)

MAJOR PLAYERS

Table: Market Share

Major Player Market Share Range

Orica Limited 22.00% - 25.00% (2004)

Wattyl Limited 17.00% - 19.00% (2004)

Barloworld Australia Pty Limited 9.00% - 11.00% (2004)

Akzo Nobel Industries Limited 7.00% - 9.00% (2003)

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T h e f i r m s i n t h e i n d u s t r y a r e s o r t e da c c o r d i n g t o t h e s i z e o f t h e i r o u t p u t .X i - t h e o u t p u t o f t h e f i r m

X - t h e o u t p u t o f i n d u s t r y

X

Xi

- t h e s h a r e o f t h e f i r m i n t h e i n d u s t r yo u t p u t

T h e r a t i o o f r l a g e s t f i r m s i n t h e i n d u s t r yo u t p u t

CX

X

X

X

X

X

X

Xri

i

rr

1

1 2 . . .





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Census Measures of Market Concentration

Concentration Ratios– Group market share data are called concentration ratios.– CRi = ∑ Xi, where Xi is market share of the ith leading firm.

– CRi = 100 for monopoly.– CRi ≈ 0 for a perfectly competitive industry.

Herfindahl-Hirschmann Index– Calculated in percentage terms, the HHI is the sum of squared market

shares for all competitors. – HHI = ∑ Xi2, where Xi2 is squared market share of the ith firm.

– HHI = 10,000 for monopoly.– HHI ≈ 0 for a perfectly competitive industry.

Limitations of Census Information– Slow reports hinder usefulness.– National statistics obscure local markets.

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N


Diagrammatic approach

No of firms cumulated from the largest

Cu

mul

ativ

e %

of

outp

ut

100%

The curve of equaldistribution of shares of the market amongfirms

The curve of real (not equal distribution

This distance measures concentration




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Multinational companies. Vertical and horizontal coordination.Multinational companies. Vertical and horizontal coordination.

DiversificationDiversification

Vertical coordinationVertical coordination

Multinational companyMultinational company

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Invest in production facilities to produce a product D

A firm X producinga good A

Buys shares of a firm Y producinga good B

Invents a new product C



DiversificationDiversification

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Invest in production facilities or buys sharesof or coordinate activities with a firm producing an input D





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Invest in facilities or buys shares of or coordinate activities with a firm providing professional training for employees




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Invest in production facilities or buys sharesof or coordinateactivities with a firm using A as an input




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Invest in production facilities or buys sharesof or coordinateactivities with a firm using A as an input

Invest in or buys sharesof or coordinate activities with a firm specialising inthe selling of product A




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A firm producinga good A in a home country

Establishes branches in other countries

Buys share ofanalogous firmsin other countries

Undertake vertical coordination measures abroad

Conduct diversificationpractices abroad



Multinational companyMultinational company

Documents

Market Structure