9 October 2000

Introduction to Market Structure Analysis: Competition and Monopoly

Lecture Outline

• Introduction to Perfect Competition, Monopoly, and the Concept of Market Structure
• Factors that Influence the Extent of Competition
• The Model of Perfect Competition
• Conditions that Lead to Monopoly
• The Model of Monopoly
• Monopsony vs. Monopoly
• Measurement of Profit Rates: Performance
• The Link Between Market Structure and Performance
• Market Structure and Competitive Strategy
• Summary of Market Structure Characteristics for Competition and Monopoly

Lecture Notes

Introduction to Perfect Competition, Monopoly, and the Concept of Market Structure

• Number and size of existing and potential entrant sellers, and number and size of existing and potential entrant buyers
• The extent of entry/exit (sunk) costs and other difficulties associated with market entry (or exit)
• The extent to which products are similar or different across firms
• The extent of economies of scale in production
• The extent to which costs are similar or different across firms
• The extent of transaction costs, and the extent of travel or information costs on the part of buyers

What do we mean by a market? A market is made up of an economic institution (set of rules governing how price is set and who trades), a set of traders, and a communication environment. The market facilitates voluntary trades between buyers and sellers. Thus, for example, fine art may be sold in a market that consists of an English auction institution (auctioneer calls for price bids), a set of potential buyers and a seller, and communication occurs via verbal and visual signals in a 'face-to-face' environment. The market for loaves of bread occurs through a posted-price economic institution, involves a set of rival grocery or bakery sellers and consumer buyers, and verbal face-to-face communication.

What do we mean by a potential entrant? A potential entrant seller is a firm that can and would enter a market under sufficiently favorable circumstances. Potential entrants constrain the behavior of existing firms in the market.

Perfect competition refers to an idealized state in which:

• There are many buyers and sellers, each of whom is small in size relative to the overall market
• There are no entry/exit costs or other difficulties associated with entry/exit
• products made by different sellers are effectively identical
• Economies of scale in production are exhausted at low output levels, which explains in part why there are many relatively small sellers
• Costs are identical across firms
• There are no transaction, travel orinformation costs

A consequence of this market structure is that there is vigorous competitive rivalry amongst the sellers, and buyers are unable to collude or monopsonize the market. Because sellers are so small relative to the overall market, no one seller can significantly affect market price by way of its output-setting behavior, implying that sellers are price takers -- they optimize by taking the market price as a parameter unaffected by their own behavior.

The other polar market structure form is pure monopoly. Monopoly implies the following market structure characteristics:

• There is one seller, and any number of buyers.
• There are high market entry/exit costs or other barriers to potential entrants, though these may recede over time
• products made by other sellers are sufficiently differentiated as to be in different markets, and thus do not provide any competitive pressure on the monopolist
• Economies of scale in production often occur at relatively high output levels, though this is not necessary; for natural monopoly we see economies of scale that occur at very high output levels, which gives the single firm a cost advantage over smaller potential entrants
• The monopolist's cost structure may or may not be any different than those of other sellers
• High transaction, travel, or information costs can lead to or sustain a monopoly structure, though they also be small or nonexistent

As a consequence of this market structure, in the short run monopolists are price makers who recognize that their sales output has a direct impact on market price. As a consequence monopolists set P and market-clearing Q simultaneously.

Factors that Influence the Extent of Competition

• The number and relative size of sellers (and buyers)
• The extent to which the sellers' products are similar

The number and relative size of sellers depends on:

• Product characteristics: some product characteristics such as perishability can limit the number of sellers competing in a given regional market.
• Production and cost characteristics: Products that feature very high fixed costs will also feature large economies of scale, which will naturally tend to restrict the number of sellers in a particular market. High fixed cost products include oil/gas/water pipelines, auto/jet/military product manufacture, etc.
• Entry/Exit conditions: If there are large sunk costs associated with entry into a market (e.g., image advertising campaigns, development of specialized expertise, investment in specialized equipment, etc), and if there is a probability that the entrant will have to exit because market conditions failed to live up to forecasts, then there is an exit cost that reflects the sunk-cost investment. In addition, patents, copyrights, and trademarks are legal barriers to entry. Regulations limiting plant closures, or that require substantial regulatory approval can limit entry.

The degree of competition is also affected by the number of buyers. If there is only one buyer, or if buyers can act collusively like a single entity, then we have a condition called monopsony. Very large firms can sometimes act as monopsony buyers of labor and other inputs, and big retailers like K-mart and Wal-mart can sometimes use their size to negotiate more favorable wholesale prices of the goods they retail.

The extent to which products are identical or differentiated also has an impact on the extent of competition. In fact, we define a product market by the set of goods/services that are sufficiently similar as to be considered close substitutes by buyers (nb: the cross-price elasticity concept...). If products are highly differentiated, then there are fewer products in a given market, which leads to less 'competitive pressure'. Thus it is usually (though not always) in a firm's best interest to differentiate its product(s) from those of its rivals.

How can travel or information costs affect competition? High travel costs and geographically dispersed sellers can reduce the number of sellers in a given geographical market, thus lessening competition. To see this, consider auto dealerships in Arcata. Are auto dealerships in the greater Bay area in the same geographical market? How about those in Eureka? Thus gas stations on isolated stretches of major highways are able to charge more for their gas than stations located in larger metro areas. Information costs, like travel costs, limit competition by creating a distance between the known sellers and the unknown sellers. This is why firms pay to engage in informative advertising. If buyers are quite poorly informed of prices or product characteristics at rival grocery stores or computer stores, then the store they patronize is subject to less price competition than would occur if consumers were much better informed.

The Model of Perfect Competition

• There are many buyers and sellers, each of whom is small in size relative to the overall market
• There are no entry/exit costs or other difficulties associated with entry/exit
• products made by different sellers are effectively identical
• Economies of scale in production are exhausted at low output levels, which explains in part why there are many relatively small sellers
• Costs are identical across firms
• There are no transaction, travel orinformation costs

It is difficult to find actual market structures that perfectly match this idealized market structure, but it is useful as a benchmark for comparing less competitive market structures by. We think that some commodities and financial markets have many of the characteristics of perfect competition

In competitive markets, firms are small relative to the market and so take the market price as being independent of their output decisions. Thus from the profit expression

profit = PQ - C(Q)

we get the condition for a firm's optimal output:

P = MC

We are used to the optimal output condition being MR = MC. Why is MR = P in the case of perfect competition? Because market P is unaffected by the firm's output level -- it is a fixed parameter.

As a consequence, competitive firms supply along their marginal cost curves. Why? Because as market P varies, a firm's QS is determined by where P = MC. Thus the firm's MC curve is identical to its supply curve.

How do we get market supply? By horizontally summing all the individual firms' supply (MC) curves. In particular, at any given price, add up the QS for each firm in the market and one gets a (P,QS) relationship for the entire market -- a market supply curve. To see this, consider TABLE 10.1 in the Hirschey/Pappas text.

QUESTIONS FOR DISCUSSION:

• What is the graphical nature of a short-run competitive equilibrium? DRAW DIAGRAMS ON THE BOARD.....
• How do we graphically calculate a representative firm's profit level?
• Comparative Statics: What happens to this short-run equilibrium
  • In an adjustment to a long-run equilibrium?
  • If demand increases? Decreases?
  • If costs rise? Fall?

WORK SOME PRACTICE PROBLEMS ON THE COMPETITIVE MODEL

Conditions that Lead to Monopoly

• Very high entry/exit costs or other entry barriers
  • Ownership of a highly valuable patent, copyright, or trademark
  • Access to technology or processes not available to others
  • Complete ownership of a key input
  • Natural monopoly: Very high fixed costs
• Government-created monopoly
• Mafia-style threats

We tend to think that many of the factors that contribute to monopoly erode in the long run. In other words, it is difficult to limit entry into a market over the long term, unless you are protected by government (or, in the case of the mafia, you effectively are the government). Even patents eventually run out, or are designed around by others. Conditions that lead to a natural monopoly can also change as markets grow and develop. Much of the deregulation movement over the last 17 years has been driven by changes in markets and the perception that many of the government-created entry barriers were no longer necessary to protect markets. Example: Sunk cost of building interstate gas pipelines made that infant industry highly risky in the '30s, as was the RR in the mid-1800s. In both cases the Gov't created franchise monopolies, protecting pipelines and RRs from entry. As these markets developed and grew, however, the need for these protections declined, and deregulation worked to remove them.

The Model of Monopoly

profit = P(Q)Q - C(Q)

Note the key difference -- P(Q) is the inverse demand function, relating QD to price along the demand curve. Thus as the monopolist sells larger and larger quantities, price falls (because the firm is moving down the market demand curve as Q rises, forcing price to fall). Thus P'(Q) is less than zero.

DRAW THE MONOPOLY DIAGRAM

QUESTIONS FOR DISCUSSION:

• What is the nature of the long-run monopoly equilibrium?
• How do we graphically calculate the monopolist's profit level?
• Comparative Statics: What happens to this short-run equilibrium
  • If demand increases? Decreases?
  • If costs rise? Fall?
  • If entry by a similar firm occurs?

Monopsony vs. Monopoly

When monopoly meets monopsony (as when there is a company town with a unionized workforce), the wage and total employment are subject to negotiation.

Measurement of Profit Rates: Performance

ROE = net income/equity.

It is useful to relate ROE to other commonly-measured performance variables:

ROE = [net income/sales]x[sales/total assets]x[total assets/equity].

Note that we have multiplied and divided by sales and total assets, and that if we let them cancel each other out we return to the first definition. But lets not do that, because each component of the right-hand-side of the second equation above is a commonly-measured performance variable:

ROE = [profit margin]x[total asset turnover]x[leverage]

Profit Margin is accounting net income expressed as a percentage of sales revenues. The profit margin shows the amount of profit earned from each $1 of sales. Since net income per $1 of sales is a reflection of high demand and low costs, it is an indicator of quality managerial performance.

Total Asset Turnover is sales revenue divided by the book value of total assets. Total asset turnover is high when a given investment in capital results in a large volume of sales. Thus even if profit margin is relatively low, a high total asset turnover means that owners' investment in capital can still yield a high rate of return, because a given $1 in invested capital yields many $'s in sales revenues, and so the small profit per $1 of sales is multiplied.

Leverage is the ratio of the book value of assets divided by stockholders' equity. When this is greater than 1, we know that the firm is using some debt or preferred stock to acquire financial capital for asset investment. The higher is leverage the more outstanding debt or preferred stock the firm uses. Leveraging is only profitable when profitability exceeds the cost of debt capital, which is most likely to occur during boom periods of the economy. Thus leveraging is risky, because during recessions, demand falls but the debt obligation does not, meaning that ROE can go negative, and leveraging will amplify this effect. Leveraging is also a tool used by ownership to discipline management -- it forces managers to do a good job, because high leverage rates put firms on the brink of losses.

The Link Between Market Structure and Performance

According to Scherer and Ross (1990), p. 446: Expirical research suggests that ... "profitability is positively associated with a seller's own market share.... Evidence of the exercise of market power--the power to raise price above marginal costs--arises in concentrated industries. That power appears to be wielded not collectively but rather by the leading seller, expecially when that firm has a cost or price advantage over its rivals."

Market Structure and Competitive Strategy

Competitive firms can enjoy positive, zero, or negative economic profits. Recall that economic profits are returns over and above all explicit and implicit costs, including opportunity cost. Since economic profit includes opportunity cost of assets owned by the firm (as well as the entrepreneur's time), normal economic profits in a competitive setting are zero. A synonym for economic profits is the term economic rents, where the term rent refers to a return over and above normal levels due to short-term changes in the market or unique attributes of the firm.

Thus in the short term there are a variety of factors than can lead to positive or negative economic profits. In a perfectly competitive long-run environment, however, there are no limits to entry and thus no way for firms to maintain positive economic profits. In other words, in highly competitive markets it is entry and exit that works to cause excessive or deficient economic profits to adjust to the normal (risk-adusted) rate of return.

In contrast, monopolies may have durable entry/exit costs that eliminate the role of entry in driving down excessive economic profits. In fact, monopolies (and other firms with market power) will spend money to both acquire a monopoly position and to maintain the entry barriers necessary to maintain a monopoly position. Thus when municipalities or universities ask for firms to bid for the right to be a monopoly supplier of some service (e.g., cable access TV or campus food service), under competitive bidding conditions we would expect that the price paid for the right to be the monopolist would be equal to the discounted present value of the anticipated future stream of economic profits that derive from this government-created monopoly. Note, however, that the government entity has adopted a 'profit center' mentality and in fact has appropriated the discounted present value of the monopoly rents. Thus municipalities may do this as a substitute for tax revenues, and universities may do this as a substitute for tuition or state appropriations, but it is the consumers who are ponying up the money to make that happen.

Summary of Market Structure Characteristics for Competition and Monopoly

As profit maximizers firms are always looking to position themselves so that they are operating in a market environment in which the structural characteristics favor the acquisition and preservation of economic rents over time. This can call for imitation of successful products in new market niches, differentiation of products to create product/brand loyalty, taking actions that limit the ability of other firms to enter (e.g., patents, copyrights, trademarks, brands, lobbying for industry self-regulation and self-certification such as with doctors, acquisition of government-created monopoly franchises, suppressing price advertising, etc).