Lecture Economics for investment decision makers: Chapter 4 - CFA In stitute

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. Chapter 4 introduce the firm and market structures. Inviting you refer.

Chapter 4

The Firm and Market Structures

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1 Introduction

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

2 Analysis of market structures

Determinants of market structures

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 and Product Advertising

Differentiation

Oligopoly Few Homogeneous/

Standardized High ConsiderableSome or and Product Advertising

Differentiation Monopoly One Unique Product Very High Considerable Advertising

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

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

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

Supply functions

Profit-maximizing price and output

Factors affecting long-run equilibrium

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)

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

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

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

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

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)