Download Market Structure Summary

Market Structure:
Market Structure is somewhat controversial, especially in today's "globalized" business
environment. The controversy surrounds the implications of mergers and acquisitions
and what governmental attitude should be toward these common business activities.
Increasing globalization has resulted from the Internet, decreased costs for travel and
communication over long distances, and increased ability to be informed about remote
markets. These make all markets more competitive as more firms get access to remote
markets, increasing the number of competitors in any given market.
So--how does market structure affect firm behavior? Should public policy intervene to
assure specific types of structure or behavior by firms? How does market structure affect
the most profitable firm strategy? Etc. This is the area for Class 3's discussion.
Market structure: the polar cases
Perfect Competition
Monopoly
1. Many small firms
1. One large (relative to mkt. Size) firm
This assumption determines whether one seller has a significant effect on the market.
It also determines how the individual firm views market signals (as personal or not).
2. Many small buyers
2. Many small buyers
This assumption assures that no buyer has a significant effect on the market.
This allows the market structure discussion to focus on firm behavior, taking consumer
behavior as given.
3. Homogeneous product
3. "Unique" product
This assumption defines the inter-firm substitutability of the products in the industry.
Assumptions 1-3 define the "customer loyalty" (price elasticity) since they define
The extent to which there are good substitutes for a firm's product.
4. Free entry and exit
4. Some barriers to entry
This assumption determines if there will be adjustments in the long run affecting profits.
That is, can firms enter in response to profit potential. If so, profits will be short-lived.
5. Perfect information
5. Perfect information
This assumption is to simplify our life during the early discussions. Clearly, information
is not perfect and some non-optimal deals are consummated. Also, information is costly
and creates some "friction" in the operation of markets. These effects, while important,
need to be abstracted from initially to better understand market operation.
Implications of Perfect Competition:
Assumptions 1-3 assure that there is no product loyalty and that no one firm can
significantly affect the market.
1. If you raise your price above the market price, you will lose all sales (Q = 0).
2. If you lower your price below market price you will be overwhelmed with orders, and
not be able to fill them all.
3. If you set a price equal to the market price, you can sell all you want to at this price.
Given this, you will set the market price and you "act as-if" you were facing a horizontal
demand curve at the market price.
Given this last (horizontal demand curve), adding one more unit sales brings in price
since I do not have to drop price to get the sale. Thus Marginal Revenue (MR) is equal
to Price:
MR = P
for a competitive firm.
Profit maximization calls for
How Much?
Increase quantity as long as the additional unit adds to profit (MR > MC)
Stop adding units when the added profit is zero (MR=MC)
Do not produce and sell units that decrease profit (MR<MC)
Whether?
At this quantity, is the firm better off producing and selling the optimal quantity or not
producing any units?
If Total Revenue [which is optional] > Total Variable cost [which is optional]
The firms is better off producing and selling the optimal quantity.
If TR<TVC, the firm is hurt by producing and it should shut down.
Total Fixed Costs are not considered because they are due regardless of the decision.
Example:
Covering Variable Costs
Not covering Variable Costs
| Producing Not Producing | Producing Not Producing|
Total Revenue
| 1000
0
| 900
0
|
Total Variable Cost | -800
0
| -1000
0
|
Total Fixed Cost
| -300
-300
| -300
-300
|
Profit
| -100
-300
| -400
-300
|
Profits lead to entry of new firms in response to the profit opportunity. This increases the
supply of products in the market driving down price, decreasing profit toward zero.
Losses lead to exit of the weakest firms, decreasing supply, increasing price. This
increases profits toward zero.
These entries or exits both drive profit toward zero, and continue until there is no more
incentive for entry or exit. Thus after all movements have been possible (in the long run),
profits for the firms will be zero. (Adding some realism, those firms with a cost
advantage will make some profit to the extent that no other firm can replicate their cost
structure.)
Firm size will also adjust toward the optimal (minimum average cost in the long run) as
the price is driven down and only the efficient survive.
Implications of Monopoly:
Since the firm is the only firm, the market demand is the firm demand. Thus there is a
limit to the number of units that can be sold at each price. In order to sell more, the firm
must decrease the price (to attract new customers). Under the assumption that every
customer gets the same price, decreasing price has a good news and bad news. The good
news is that there are additional customers at this lower price. The bad news is that all
customers who would have paid more, now pay the new lower price. Thus, there is a loss
in per unit revenue which must be deducted from the additional customer revenue.
Example: 100 customers at $10 = $1000 revenue
101 customers at $ 9 = $ 909 revenue
The change consists of $9 for the additional customer minus $100 lost in per unit revenue
from the first 100 customers. This is a VERY inelastic demand
MR = -91/1 = -91
Elasticity = (ΔQ/ΔP)(P/Q) = (1/{-1})(9.5/100.5) = -.095
MR = P(1+{1/Elasticity}) = 9.5 (1 - (1/.095)) = -91
Example 2:
100 customers @ $10 = $1000 revenue
120 customers @ $ 9 = $1080 revenue
The change consists of $ 9 per customer for 20 more customers = $180 additional
revenue minus $100 less from the previous 100 customers. This is elastic demand.
MR = 80/20 = +4
Elasticity = (ΔQ/ΔP)(P/Q) = (20/{-1})(9.5/110) = -1.73
MR = P(1+{1/Elasticity}) = 9.5 (1-(1/1.73)) = +4
What all this means is that MR < P for the monopoly firm.
THE FOLLOWING IS REPEATED FOR COMPLETENESS, BUT IS THE SAME
AS ABOVE. THE TWO DIFFERENCES COME FROM
1. MR< P
We'll talk about the implications of this later.
2. WITH BARRIERS TO ENTRY, THERE IS NO ENTRY IN RESPONSE
TO PROFITS. HENCE, PROFIT CAN BE MAINTAINED IN THE LONG RUN.
How Much?
Increase quantity as long as the additional unit adds to profit (MR > MC)
Stop adding units when the added profit is zero (MR=MC)
Do not produce and sell units that decrease profit (MR<MC)
Whether?
At this quantity, is the firm better off producing and selling the optimal quantity or not
producing any units?
If Total Revenue [which is optional] > Total Variable cost [which is optional]
The firms is better off producing and selling the optimal quantity.
If TR<TVC, the firm is hurt by producing and it should shut down.
Total Fixed Costs are not considered because they are due regardless of the decision.
The long run and the short run are indistinguishable for monopoly, except that the
firm may adjust costs to gain efficiency and hence increase profit.
One other difference between monopoly and competition is that quantity will be lower,
because
P > MR = MC leads to never reaching the point where P = MC. This leads to
some goods, for which the society value (shown by the demand curve) is greater than the
society value (shown by the marginal cost curve) will not be produced. This decreases
the value created by business in the economy. The resources not used in this industry
will be used in another where they create goods and services of lower value than those we
miss out in this industry. We know this because the Marginal cost includes the
opportunity cost of these goods that could be produced, hence measuring the value
created when the resources are diverted.
Most industries are between monopoly and competition. These will be discussed next
class.
Pricing Strategy Material:
There are some assumptions made in the calculations.
1. Average variable costs are assumed to be constant. This assumption works for small
changes, but may lead to trouble for large changes. The book shows how fixed
increments in these costs can be handles. Non-linearities are a complexity issue, not a
theory issue for this context. But be aware of the assumption.
2. Because AVC is fixed, MC = AVC. As the book points out, only incremental costs
(marginal costs) are relevant. If AVC is rising (falling), MC>(<)AVC, and our answers
would be different. In Nagle, read MC when the say (A)VC.
3. There is an implicit assumption that the firm is reasonably comfortable with its current
position. Thus the focus on changes from the current position. If this is not so, a more
global analysis should be done. That is, this analysis assumes adjustments from the
current position.
See the book for the formulas. The sense of these definitions is that the contribution
margin is the profit recovery rate from any change in the firm. So if price is dropped,
there is a loss of revenue from previous customers that must be recovered through
additional customers. The recovery rate is the (adjusted) contribution margin. The break
even formulas indicate how many additional units are necessary to recover the loss
incurred. If the firm can count on this many units increase or more, then the drop in price
does not decrease profit. For price increases, the formula will give the maximum number
of units that can be lost and still have the same profit.
The additional formulas adjust for changes in semi-fixed costs, such as additional
equipment needed for expanding output.
The last formula in the chapter deals with responses to competitive price competition. If
a major competitor drops price, what is the maximum number of units you can lose
before you must drop price in response. The issue here is not keeping the previous level
of profit--this will not happen. The issue is comparing the two positions of maintaining
price at a lower quantity or trying to defend market share by matching the price drop.
All of this material is designed to help you make decisions in an environment when you
do not know price elasticity, but in which you can make reasonable guesses about the
impact of a given price change. This is a more feasible quantitative necessity, and does
not require sophisticated statistical analysis. Elasticity estimates do require statistical
estimation and we will talk later in the course about how to do this (the structuring and
use part of this).
The continuum is as below:
Perfect Competition
Monopolistic Competition
Oligopoly
Monopoly
Many Small sellers
Many Small sellers
Few sellers
One seller
Affects the number of alternative providers available to customers ( number of substitutes). This affects the elasticity of demand for the firm.
Many small buyers
Many small buyers
Many small buyers
Many small buyers
Assures that the market power is only on the selling side. That is, the buyers do not have the power to influence the price.
Homogeneous Product
Differentiated Product
Differentiated Product “Unique” Product
Affects the ability of customers to substitutes the product of one firm for that of another (closeness of substitutes). This affects the elasticity of
demand for the firm.
Free Entry and Exit
Free Entry and Exit
Some Barriers
Strong Barriers
Determines whether economic profits attract new firms driving down price or not. With barriers the firm can have long term profits, allowing
them to raise price to maximize profits without fear of new competition to eat into their customer base.
Perfect Information
Perfect Information
Perfect Information
Perfect Information
Assures that everyone knows where the best deal is, minimizing the mistakes made, making the outcome more deterministic. Information in
the real market is costly, meaning that mistakes will be made. This is an assumption of this analysis that can be relaxed at a later date once the
relationships here are understood.