CHAPTER 4THE FIRM AND MARKET STRUCTURESPresenter’s namePresenter’s titledd Month yyyy

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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

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

Market Structure

Number of Sellers

Degree of Product

Differentiation

Barriers to Entry

Pricing Power of

Firm

Nonprice Competition

Perfect competition

Many Homogeneous/ Standardized

Very Low None None

Monopolistic competition

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

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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

Quantity

P

Q

MC3

MC2

MC1

MR

MR

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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.

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

• Price and output at point at which Marginal revenue = Marginal cost

• Economic profit possible in the short run, but zero in the long run

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

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

• Economic profits attract entrants into the market.

• Economic profit is zero in the long run.

• Demand = Marginal revenue and Average revenue

Monopolistic Competition

• Economic profits attract entrants into the market.

• Economic profit is zero in the long run.

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.

- Ranges from 0 (perfect competition) to 100 (monopoly)

- 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

The Herfindahl–Hirschman Index (HHI) is the sum of the squared market shares of the top N companies.

- The higher the HHI, the more concentrated

- Advantages

- 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).