Transcript Chapter 4The Firm and Market Structures

CHAPTER 4
THE FIRM AND MARKET
STRUCTURES
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1. INTRODUCTION
Market
Structure
Degree of
Competition
Profitability
The market structure and the degree of competitiveness in the
industry affect a firm’s pricing and output strategy and, eventually,
its long-run profitability.
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2. ANALYSIS OF MARKET STRUCTURES
Perfect
Competition
• Large number of
firms
• Homogeneous
product
• Single producer
unable to
influence market
prices
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Monopolistic
Competition
• Large number of
firms
• Product
differentiation
Oligopoly
• Small number of
firms
• High barriers to
entry
• Nonprice
competition
• Interdependence
of firms (e.g.,
retaliation)
Monopoly
• Single firm
• Exercises power
in pricing and
output
• Restricted entry
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DETERMINANTS OF MARKET STRUCTURES
Number and relative size of firms
Degree of product differentiation
Power of the seller over pricing decisions
Relative strength of barriers to market entry and exit
Degree of nonprice competition
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CHARACTERISTICS OF MARKET STRUCTURE
Barriers to
Entry
Pricing
Power of
Firm
Nonprice
Competition
Homogeneous/
Standardized
Very Low
None
None
Many
Differentiated
Low
Some
Advertising
and Product
Differentiation
Oligopoly
Few
Homogeneous/
Standardized
High
Some or
Considerable
Advertising
and Product
Differentiation
Monopoly
One
Unique Product
Very High
Considerable
Advertising
Market
Structure
Number
of Sellers
Perfect
competition
Many
Monopolistic
competition
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Degree of
Product
Differentiation
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DEMAND, REVENUES, COSTS, AND PROFIT
• Perfectly competitive market:
- The price is the lowest for all market structures.
- Price = Marginal revenue = Marginal cost.
- Economic profit is zero in the long run.
- Elasticity is infinite because of the abundance of substitute products and
competitors.
• Monopolistic competition:
- The price is higher relative to that in a perfectly competitive market.
- Marginal revenue = Marginal cost, where the marginal cost includes the cost
of product differentiation.
- Economic profit is possible in the short run with differentiation but zero in the
long run.
- Elasticity increases as firms enter the industry, which drives the price down.
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DEMAND, REVENUES, COSTS, AND PROFIT
• Oligopoly
- Marginal revenue = Marginal cost, where cost includes product differentiation.
- The price depends on the pricing of competitors and the assumptions made
regarding competitors’ reactions to price changes.
- Barriers to entry allow firms in an oligopolistic market to earn economic profits.
- Price elasticity depends on whether the price is increased (relatively inelastic) or
decreased (relatively elastic).
- Kinked demand curve
Price
MR
MC3
MC2
P
MC1
MR
Q
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Quantity
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DEMAND, REVENUES, COSTS, AND PROFIT
• Monopoly
- Marginal revenue = Marginal cost, where marginal cost includes the cost of
differentiation.
- Monopolists sell at higher prices than other market structures.
- Barriers to entry allow the monopolist to earn economic profits.
- As long as marginal revenue is positive, demand is elastic.
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SUPPLY FUNCTIONS
Perfect
Competition
• Supply curve for
the market is the
sum of individual
supply curves of
individual firms.
• Long-run
marginal cost
schedule is
firm’s supply
curve.
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Monopolistic
Competition
• No well-defined
supply function
that determines
output.
Oligopoly
• No well-defined
supply function
that determines
output.
Monopoly
• No well-defined
supply function.
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PROFIT-MAXIMIZING PRICE AND OUTPUT
Perfect
Competition
Monopolistic
Competition
• Price and output
at point at which
Marginal
revenue =
Marginal cost
• Economic profit
possible in the
short run, but
zero in the long
run
• Price and output
at point at which
Marginal
revenue =
Marginal cost
• Economic profit
possible in the
short run, but
zero in the long
run
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Oligopoly
• Cannot
determine price
and output
without
considering
pricing strategy
• Consider
retaliation in
pricing and
output decision
making
• Kinked demand
curve
Monopoly
• Marginal
revenues =
Long-run
marginal cost
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FACTORS AFFECTING LONG-RUN EQUILIBRIUM
Perfect
Competition
Monopolistic
Competition
• Economic profits
attract entrants
into the market.
• Economic profit
is zero in the
long run.
• Demand =
Marginal
revenue and
Average
revenue
• Economic profits
attract entrants
into the market.
• Economic profit
is zero in the
long run.
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Oligopoly
• Long-run profits
are possible.
• Profits attract
entrants.
Monopoly
• The demand
curve is
negatively
sloped.
• There are
sufficient
barriers to entry,
so there are no
new entrants.
• The unregulated
monopoly
produces profits
in the long run.
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IDENTIFYING MARKET STRUCTURES
Methods of identifying market structures
1. Econometric approaches
- Goal is to estimate the elasticity of supply and demand.
- Issue is that only equilibrium price and quantity can be observed, not the
entire demand and supply (problem of endogeneity).
- Time-series regression analysis requires a large number of observations,
which may not be practical because the market structure may have
changed over time.
- Cross-sectional regression analysis requires a large amount of data and is
affected by specific proxies for demand.
2. Measures of concentration
- Concentration ratio
- Herfindahl–Hirschman Index (HHI)
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CONCENTRATION MEASURES
The concentration ratio is the ratio of
the sales of the 10 largest firms in the
industry divided by the total sales of
the industry.
The Herfindahl–Hirschman Index
(HHI) is the sum of the squared
market shares of the top N
companies.
- Ranges from 0 (perfect
competition) to 100 (monopoly)
- The higher the HHI, the more
concentrated
- Advantages
- Advantages
- Easy to compute
- Disadvantages
- Does not quantify market power
- Does not consider the ease of
entry into the market
- Unaffected by mergers of the
larger competitors
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- Easy to compute
- Affected by mergers of the larger
competitors
- Disadvantages
- Does not quantify market power
- Does not consider the ease of
entry into the market
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CONCLUSIONS AND SUMMARY
• There are four categories of market structures: perfect competition,
monopolistic competition, oligopoly, and monopoly.
• The categories differ because of the following characteristics:
- Number of producers
- Degree of product differentiation
- Pricing power of the producer
- Barriers to entry of new producers
- Level of nonprice competition
• A financial analyst must understand the characteristics of market structures in
order to better forecast a firm’s future profit stream.
• The optimal level of production in all market structures is the quantity at which
marginal revenue equals marginal cost.
• Only in perfect competition does the marginal revenue equal price. In the
remaining structures, price generally exceeds marginal revenue because a firm
can sell more units only by reducing the per-unit price.
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CONCLUSIONS AND SUMMARY
• The quantity and price in equilibrium differs among market structures.
- The quantity sold is highest in perfect competition, and the price in perfect
competition is usually lowest (but this depends on such factors as demand
elasticity and increasing returns to scale).
- Monopolists, oligopolists, and producers in monopolistic competition attempt
to differentiate their products so that they can charge higher prices.
- Monopolists typically sell a smaller quantity at a higher price.
• Competitive firms do not earn economic profit. There will be a market
compensation for the rental of capital and of management services, but the lack
of pricing power implies that there will be no extra margins.
• Although in the short run, firms in any market structure can have economic
profits, the more competitive a market is and the lower the barriers to entry, the
faster the extra profits will fade.
- In the long run, new entrants shrink margins and push the least efficient firms
out of the market.
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CONCLUSIONS AND SUMMARY
• An oligopoly is characterized by the importance of strategic behavior.
- Firms can change the price, quantity, quality, and advertisement of the
product to gain an advantage over their competitors.
- Several types of equilibrium (e.g., Nash, Cournot, kinked demand curve) may
occur that affect the likelihood of each of the incumbents (and potential
entrants in the long run) having economic profits. Price wars may be started
to force weaker competitors to abandon the market.
• Measuring market power is complicated, but two approaches are typically
used:
- Estimating the elasticity of demand and supply econometrically.
- Using a measure based on company revenues relative to the industry
revenues with either the concentration ratio or the Herfinda–Herschman
Index (HHI).
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