Category Archives: Market Structures

A2 Economics – the need to move to more contestable markets.

The Economist had as its main Leader an article on the lack of competition in the global market place. Too many companies have  monopoly power and earn, what the economics textbooks call,  significant ‘abnormal profits’. In 2016 a survey found that more than half of young Americans no longer support capitalism. In the past governments have made it a more level playing field.

  • US – at the start of the 20th century they broke up monopolies in railways and the energy industry. Ronald Reagan also unleashed the power of the market
  • West Germany – created competitive markets to rebuild their post-war economy
  • Britain – Margaret Thatcher exposed state-owned inefficient domestic industries to the dynamic foreign competition. She also privatised the Commanding Heights of the economy.

There are 3 tests that The Economist use to examine the market structure:

Concentration Ratios
A lot of firms have experienced inertia and become very comfortable whilst the tech firms are building significant amounts of market power. In the US Concentration ratios between 1997 and 2012 have risen in approximately 600 census industries, with the weighted average market share of the top 4 firms growing from 26% to 32%. 10% of the US economy is made up of industries where 4 firms have more than 66% of the market share. The concentration ratio is the percentage of market share taken up by the largest firms. It could be a 3 firm concentration ratio (market share of 3 biggest) or 5 firms concentration ratio.

Abnormal Profits
In a healthy economy you would expect profits to be competed down, but the free cashflow of companies is 76% above its 50-year average, relative to GDP. In Europe the trend is similar, if less extreme. The average market share of the biggest four firms in each industry has risen by three percentage points since 2000. On both continents, dominant firms have become harder to dislodge.

Openness
Of US firms that made very high profits in 1997, 50% still did in 2017. There is a reduction in new firms and with a lowdown in globalisation industries that are less exposed to trade have become more dominant in the market place – the domestic market. The current protectionist policies of the Trump Administration don’t help to breakdown the barriers to entry and as the high stock values of profitable firms show, investors believe their advantages will continue. Powerful firms tend to stay and of the total capital spending and R&D done by America’s leading 500 companies the top 20 firms account of 38% of this spending.

The Contestable Market – A2 Economics – Theory

The degree of contestability of a market is measured by the extent to which the gains from market entry for a firm exceed the cost of entering (i.e. the cost of overcoming barriers to entry), with the risks associated with failure taken into account (the cost associated with any barriers to exit). Accordingly, the levels of barriers to entry and exit are crucial in determining the level of a market’s contestability. Barriers to exit consist of sunk costs, that is to say costs that cannot be recovered when leaving the market. The contestable markets approach suggests that potential entrants consider post‑entry profit levels, rather than the pre-entry levels suggested by neo‑classical theory.

Obviously no market is perfectly contestable, i.e. with zero sunk costs. In modern economies it is the degree of contestability which is relevant, some markets are more contestable than others. Also just because there have been no new entrants to a market over a given period of time does not mean that this market is not contestable. The threat of entry will be enough to make the existing (incumbent) firms behave in such a way as to recognise this, i.e. by setting a price which doesn’t attract entry and which only makes normal profits.

Markets which are highly contestable are likely to be vulnerable to ‘hit and run competition’. Consider a situation where existing firms are pricing at above the entry‑limit level. Even in the event that existing firms react in a predatory style, new entry will be profitable as long as there is a time lag between entry and the implementation of such action. Having made a profit in the intervening period, the new entrant can then leave the market at very little cost.

In a contestable market there are no structural barriers to the entry of firms in the long-run. If existing businesses are enjoying high economic profits, there is an incentive for new firms to enter the industry. This increases market competition and dilutes monopoly profits for the incumbent firms.
Market contestability requires there are few sunk costs. A sunk cost is committed by a producer when entering an industry but cannot be recovered if a firm decides to leave a market.

The video below on the Airline Industry in the US from Commanding Heights series is a good example of breaking down monopoly power.

Sources:

The Economist – The Next Capitalist Revolution – November 17th 2018

Anforme – A2 Level Economics Revision Booklet

A2 Revision: The Perfectly Competitive Firm and the Market

Supernormal, normal, and subnormal profit only identified what happens to the firm. However it is important to be aware of what is happening in the market as a whole. Take for instance a firm making supernormal profits. The price that the firm charges is determined by what is happening in the market (supply and demand). If a firm makes supernormal profits this attracts other firms into the industry to take advantage of these profits. Therefore the supply of firms in the market increases which in turn reduces the price that firms can charge and they now make normal profits and are in the long-run see fig below.

Airline price discrimination

Price discrimination involves charging different prices to different sets of consumers for the same good or service. So when you are on your next flight there are going to be different fares for the same class of seat whether it be in economy, business class or first class. What variables at work to bring about price discrimination in airline routes?

  • What day of the week you fly – Monday and Friday are usually peak times for business so you should find that fares are expensive. Also because it is usually for business purposes it is assumed that firms will be paying for the flights and therefore are prepared to pay more.
  • Times of the day – morning and evening tend to be more expensive as this is peak time.
  • How competitive the route is – if there is a lot of competition fares will be cheaper to the extent that there maybe predatory pricing. There is a good piece in the video showing the fares for flights from Montreal to St Johns Newfoundland. Once low cost carriers entered the market Air Canada dropped their price below cost.
  • Reputation of each airline – better reputation = higher fare

The video below is a very good especially the fare structure on the New York to Los Angeles route.

A2 Revision – Imperfect Competition AR, MR and TR curves

fig08-11You should note the following from the graphs:
• to sell an additional unit of a commodity, the monopolist must reduce the price of all units sold. This therefore means the AR curves falls.
• as the price on all units must be lowered to sell the higher output, MR is lower than the price of the marginal unit(AR)
• TR at first increases with output but as price is reduced to sell more goods and services, eventually falls.
• where MR = 0 TR is at a maximum.

A2 Revision – Oligopoly and the kinked demand curve – download

With the A2 Essay paper next week I thought something on the kinked demand curve might be useful. I alluded to in a previous post that one model of oligopoly revolves around how a firm perceives its demand curve. The model relates to an oligopoly in which firms try to anticipate the reactions of rivals to their actions. As the firm cannot readily observe its demand curve with any degree of certainty, it has got to estimate how consumers will react to price changes.

In the graph below the price is set at P1 and it is selling Q1. The firm has to decide whether to alter the price. It knows that the degree of its price change will depend upon whether or not the other firms in the market will follow its lead. The graph shows the the two extremes for the demand curve which the firm perceives that it faces. Suppose that an oligopolist, for whatever reason, produces at output Q1 and price P1, determined by point X on the graph. The firm perceives that demand will be relatively elastic in response to an increase in price, because they expects its rivals to react to the price rise by keeping their prices stable, thereby gaining customers at the firm’s expense. Conversely, the oligopolist expects rivals to react to a decrease in price by cutting their prices by an equivalent amount; the firm therefore expects demand to be relatively inelastic in response to a price fall, since it cannot hope to lure many customers away from their rivals. In other words, the oligopolist’s initial position is at the junction of the two demand curves of different relative elasticity, each reflecting a different assumption about how the rivals are expected to react to a change in price. If the firm’s expectations are correct, sales revenue will be lost whether the price is raised or cut. The best policy may be to leave the price unchanged.

With this price rigidity a discontinuity exists along a vertical line above output Q1 between the two marginal revenue curves associated with the relatively elastic and inelastic demand curves. Costs can rise or fall within a certain range without causing a profit-maximising oligopolist to change either the price or output. At output Q1 and price P1 MC=MR as long as the MC curve is between an upper limit of MC2 and a lower limit of MC1.

Criticisms of the kinked demand curve theory.
Although it is a plausible explanation of price rigidity it doesn’t explain how and why an oligopolist chooses to be a point X in the first place. Research casts doubt on whether oligopolists respond to price changes in the manner assumed. Oligopolistic markets often display evidence of price leadership, which provides an alternative explanation of orderly price behaviour. Firms come to the conclusion that price-cutting is self-defeating and decide that it may be advantageous to follow the firm which takes the first steps in raising the price. If all firms follow, the price rise will be sustained to the benefit of all firms.

If you want to gradually build the kinked demand curve model download the powerpoint by clicking below.
Oligopoly

A2 Revision – Monopoly and Deadweight Loss

A topic in the A2 syllabus is Market Failure with special emphasis on Monopoly and Deadweight Loss.

In Perfect Competition we stated that the force of supply and demand establish an equilibrium situation in which resources are used most efficiently – MC (Supply) = AR(Demand) . Furthermore, in perfect competition the firm produces at MC = MR (profit max) which is also the same as producing at MC = AR (allocative efficiency). This is because AR and MR are the same in perfect competition. Therefore the same output represents allocative efficiency and profit max. Remember that long-run Perfect Competition is a significant output as it is where:
MC = MR – Maximum Profit or Minimum Loss
MC = AR – Allocative Efficiency (Supply = Demand)
AC = MC – Technical Optimum – Productive Efficiency

However for a monopolist because the AR and the MR curves are different we get separate outputs for Allocative Efficiency and Profit Max. The graph below shows that at profit maximising equilibrium, output Q2 is less than that in a competitive market (Q1), and the demand and supply (MC) curves do not intersect. Q1 represents the Allocative Efficiency level of output and P1 the price. The shaded area therefore represents the loss of allocative efficiency or the deadweight loss.

Teaching MC=MR with M&M's

Having just completed Perfect and Imperfect Competition with my Year 13 class I used a couple of packets of M&M’s to drum home the concept of marginal analysis MC=MR. It has always been something that students have struggled with but I am hoping this experience of creating graphs with M&M’s might help their understanding and when to use the concept.

Profit is maximised at the rate of output where the positive difference between total revenues and total costs is the greatest. Using marginal analysis, the firm will produce at a rate of output where marginal revenue equals marginal cost. Below are a few of the graphs done using M&M’s.
MM1MM3MM4.jpegMM2

 

Tacit Collusion at Martha’s Vineyard petrol stations.

The Economist ‘Free Exchange’ had an article about tacit collusion and the role of algorithms in setting prices. Martha’s Vineyard, a popular holiday retreat for the wealthy in the US, has four petrol stations who had a price-fixing suit brought against them for what was seen as extremely high petrol prices when compared to those at nearby Cape Cod. The judges found no evidence that there was agreement between petrol stations to raise prices although they did note that the market encouraged tacit (silent) collusion amongst the four petrol stations. Whereas explicit collusion over prices is illegal, tacit collusion is not. The conditions conducive for tacit collusion include:

  1. The market is concentrated and there are strong barriers to entry from competitors. Martha’s Vineyard is cut off from the mainland.
  2. Prices are transparent in a way that renders any attempt to steal business by lowering prices self-defeating. A price cut posted outside one petrol station will soon be matched by the others. And if one station raises prices, it can always cut them again if the others do not follow.
  3. The product is a small-ticket and frequent purchase, such as petrol. Markets for such items are especially prone to tacit collusion, because the potential profits from “cheating” on an unspoken deal, before others can respond, are small.

Petrol Price App

Although the consumer maybe able to find out the price of petrol at various stations through a smartphone app but this app makes it easier for the petrol stations to monitor and match each others’ prices. A retailer would have little incentive to cut prices and as other competitors would be able to match their prices instantly leaving everyone worse off.

Collusion in oligopoly

It is often observed that oligopolistic firms are torn between two conflicting desires: The wish to compete on one hand, and the wish to collude on the other. The hope of winning any price war tempts some firms (particularly those with significant advantages, such as lower costs) but collusion is an attractive proposition given the desire to remove the uncomfortable uncertainty that interdependence brings to the market. Collusion reduces the fear of competitive price cutting or retaliatory advertising which could reduce industry profits.

Where oligopolists agree formally or informally to limit competition between themselves they may set output quotas, fix prices, or limit product promotion or development.

A formal collusive agreement is called a cartel. A cartel can achieve the same profits as if the industry were a monopoly. In the graph below the total market or industry demand curve is shown as D and the corresponding marginal revenue curve is MR. The cartel’s marginal cost curve (MC) is the horizontal sum of the marginal cost curves of the members of the cartel. The cartel will set a price of p1 (MC = MR) where profits are maximised. Alternatively the cartel could set output at q1 by giving each cartel member an output quota. This would produce the same price (p1).

By contrast, p2 shows the marginal cost price which would be the price under perfect competition, with q2 showing the corresponding output. This means that the cartel will operate with a higher price and lower output when compared to perfect competition.

Cartel with Monop Price

Cartel with a monopoly price

Covert (formal) collusion occurs where firms meet secretly and make decisions about prices or output. Tacit (informal) collusion is much more difficult to control. This is when firms act as if they have agreements in place without actually having communicated with each other.

Collusion between firms whether formal or informal is more likely when:

• there are only a few firms in the industry, so reaching an agreement is easier and any cheating can be spotted quickly.

• they have similar costs of production and methods of production making any agreement on price easier to reach.

• the firms produce similar products. Cartels have been common in industries such as cement production in recent years.

• the products have price inelastic demand meaning that a rise in price by the cartel will lead to a rise in sales revenue for the firms.

• the laws against collusion in a country are weak or ineffective.

Collusive agreements often prove difficult to sustain. Most are illegal as they raise prices to the detriment of the consumer. They cannot, therefore, be enforced by contract, even if cheating could be detected. Each and every party to the collusive agreement has an incentive to cheat by producing more than agreed. This will suppress price slightly, but the firm can still take advantage of artificially high prices as long as the other firms do not cheat as well. However, stable market conditions (a small number of firms; similar costs of production; similar products; high barriers to entry; easy detection of cheating on the agreement) make joint profit maximisation feasible.

Sunk Costs, Market Structure and Football Clubs

Over the holidays I read Stefan Szymanski’s book “Money and Football – A Soccernomics Guide”. Szymanski also co-authored “Soccernomics” with Simon Kuper. There were various references to economic theory through the book which I will refer to on this blog.

Market Dominance

Dominance in a market is often associated with the lack of competition whether it be due to monopoly power, predatory pricing, the scale of investment etc. However this is not the case when it comes to football. Szymanski mentions the fact that there are 27 professional teams withn a 50 mile radius of Manchester Utd. If fans don’t like United, there are plenty of alternatives as there are in Madrid which has 5 professional clubs. In some countries football rivals play in the same stadium:

  • In Germany: Bayern Munich and TSV 1860 Munich,
  • In Italy: Inter Milan and AC Milan,
  • In Switzerland: FC Zurich and FC Grasshopper
  • In Brazil: Botafogo, Flamengo and Fluminense

Football Clubs.jpgDominance in markets usually occurs because of the initial investment required to compete in the first place – set-up costs. If you look at the railway industry (which could be said to be a natural monopoly) the cost of putting down new train tracks by the existing ones or a new line would be excessive and the ability to cover these costs would very difficult. Any benefit that may arise from competition would be diminished by the cost of duplication.

Dominance is easy to explain if there are very large set-up costs, which, once spent, cannot be recovered other than by operating in the industry. Economist refers to these costs as Sunk Costs.

Dominance in a market can also occur in markets where there are less sunk costs. Take for instance the soft drinks industry as an example. It remains relatively inexpensive to set-up a production plant to bottle soft drinks but Coca-Cola dominates the world market with 42% market share, followed by Pepsi with 28%. Their dominance is through advertising which makes up the majority of the sunk costs. Advertising is an example of ‘endogenous’ sunk costs which are determined by the firm as opposed to ‘exogenous’ sunk costs which are determined by technological requirements.
Premier League Players.jpgIn professional football the focus is on player investment rather than advertising, where the big clubs are those that spend heavily on players and win league championships. Teams that win are more likely to attract a larger fan base and greater revenue. Szymanski states that the big difference between football and soft drinks is that the pattern of dominance looks the same in small markets. For instance clubs in the English Division 2 (Division 4 in the old days) still stay in existence mainly because they operate in a different market than the Premiership teams. Of the 88 clubs in the English Football League in 1923, 85 still exist, and most of them still play in the 4 English Divisions. Also those clubs in the lower Division do benefit from intense local loyalty especially through tough times with performance. When clubs get relegated to the Championship from the Premier League, although they lose revenue from TV rights their fan base remains fairly constant. However a lot of these clubs will find it hard breaking into the dominant group – Manchester City, Manchester Utd, Liverpool, Arsenal, Chelsea, Spurs – unless they receive significant funding from an investor who doesn’t expect to see a financial return or have an exceptional season without high profile players like Leicester City who won the Premiership in 2015/16.

Unlike most business in which loss-making firms shut down or merge into other businesses, football clubs almost always survive. This does not prevent dominance, but unlike most industries, it does mean that the pattern of dominance tends to look the same everywhere. Source: Szymanski