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Chapter 4 The Firm and Market Structures

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1 Chapter 4 The Firm and Market Structures
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2 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. Page 143 Notes to the presenter: It is important that the link between market structure and financial analysis be made upfront. This link is key to the participants’ understanding the relevance of this material. Market structure refers to the number and relative size of firms in an industry, and their behavior in competing for input resources and competing in the output market. The degree of competition refers to the presence of barriers (legal, resources, governmental, etc.) to entry and exit that may inhibit the free flow of resources to their best use. Profitability refers to economic profit, not accounting profit. Copyright © 2014 CFA Institute

3 2. Analysis of market structures
Perfect Competition Large number of firms Homogeneous product Single producer unable to influence market prices Monopolistic Competition 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 LOS: Describe the characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly. Pages 145–146 In perfect competition, there is a large number of firms and a homogeneous product; hence, no single producer influences market prices. In monopolistic competition, there is a large number of firms, yet there is product differentiation. An oligopoly consists of a small number of firms. Each firm in an oligopoly must consider the reactions of competitors in any pricing and output decision making. In a monopolistic market, there is a single firm that exercises control over pricing and output. Copyright © 2014 CFA Institute

4 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 LOS: Describe the characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly. Pages 146–148 The differentiating characteristics of market structures are 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, and degree of nonprice competition. Notes for the presenter: The importance of each of these dimensions is that they affect whether firms in an industry can earn economic profits and, if so, whether they can do so in the long run. These characteristics are based on Porter’s Five Forces: Bargaining power of customers Bargaining power of suppliers Threat of new entrants Threat of substitute products Competitive rivalry within an industry Copyright © 2014 CFA Institute

5 Characteristics of 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 Monopolistic competition Differentiated Low Some Advertising and Product Differentiation Oligopoly Few High Some or Considerable Monopoly One Unique Product Very High Considerable Advertising LOS: Describe the characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly. Pages 146–148 Number and relative size of firms: many for perfect competition and monopolistic competition, few for oligopoly, and one for monopoly Degree of product differentiation: homogeneous for perfect competition and oligopoly, but differentiation for monopolistic competition; unique for monopolies Barriers to entry: low for competitive markets, high for oligopoly and monopoly Power of the seller over pricing decisions: low for perfect competition and monopolistic competition, high for monopoly Degree of nonprice competition: none for perfectly competitive markets, and nonprice competition for monopolistic competition and oligopoly; monopoly does not differentiate but uses advertising to affect demand Copyright © 2014 CFA Institute

6 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. LOS: Explain the relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under each market structure. Pages 149–157, 166 In a perfectly competitive market, the price is equal to marginal revenue and marginal cost, economic profit is zero in the long run, and elasticity is infinite because of the of the abundance of substitute products and competitors. In a monopolistic competition, marginal revenue is equal to 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, and elasticity increases as firms enter the industry, which drives down the price. Notes to the presenter: In a monopolistic competitive market, firms may attempt brand loyalty (e.g., Costco). Copyright © 2014 CFA Institute

7 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 LOS: Explain the relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under each market structure. Pages 169–178 In an oligopoly, marginal revenue is equal to marginal cost (where cost includes product differentiation), price depends on the pricing of competitors and the assumptions regarding competitors’ reactions to price changes, barriers to entry allow firms to earn economic profits, and price elasticity depends on whether the price is increased (relatively inelastic) or decreased (relatively elastic). Notes to the presenter: Demand curve is illustrated in Exhibit 4-13b. There are different pricing strategies, each based on different assumptions regarding competitors’ reactions: Cournot assumption: the output of competitors will not change. Stackelberg model: leader sets its output, and then follower sets its output based on the leader’s output. Game theory becomes relevant because each firm in an oligopoly must anticipate competitors’ decisions. Collusion is possible, which may result in limited supply and a price higher than without collusion; legal, more subtle collusion is price leadership. Examples of oligopolies in the United States: Retail gas stations Cell phone market MR MC3 P MC2 MC1 MR Q Quantity Copyright © 2014 CFA Institute

8 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. LOS: Explain the relationships among price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under each market structure. Pages 181–182 With a monopoly, marginal revenue is equal to marginal cost; monopolists sell at higher prices than other market structures; barriers to entry allow the monopolist to earn economic profits; and as long as marginal revenue is positive, demand is elastic. Notes to the presenter: Examples of monopolies: Diamonds: DeBeers Cable service (local) granted monopoly by local government Another term used for barriers: “wide economic moat” Copyright © 2014 CFA Institute

9 Monopolistic Competition
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 Monopoly No well-defined supply function. LOS: Describe the firm’s supply function under each market structure. Pages 158–159, 166–167 In perfect competition, the supply curve for the market is the sum of individual supply curves of individual firms and the long-run marginal cost schedule is the firm’s supply curve. In monopolistic competition, an oligopoly, and a monopoly, there is no well-defined supply function that determines output. Copyright © 2014 CFA Institute

10 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 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 LOS: Describe and determine the optimal price and output for firms under each market structure. Pages 159–161, 167–168, 170–176, 184–185 In perfect competition and monopolistic competition, the profit-maximizing price and output is the quantity and price at which marginal revenue is equal to marginal cost. In an oligopoly, we cannot determine price and output without considering pricing strategy, but in a monopoly, the profit-maximizing point is that price and quantity at which marginal revenue is equal to long-run marginal cost. Notes to the presenter: In a monopoly, the determination of price depends on whether it is regulated. If unregulated, PM in Exhibit 4-19; if regulated, the price is determined, in part, by the regulator. Copyright © 2014 CFA Institute

11 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 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. LOS: Explain the effects of demand changes, entry and exit of firms, and other factors on long-run equilibrium under each market structure. Pages 161–163, 168, 178–179, 187–188 With perfect competition, economic profits attract entrants into the market, driving economic profit to zero in the long run. Demand is marginal revenue and average revenue. In monopolistic competition, economic profits attract entrants into the market, yet economic profit is zero in the long run. In an oligopoly, long-run profits are possible, but profits will attract entrants if barriers to entry are not sufficiently strong. In a monopoly, the demand curve is negatively sloped. There are sufficient barriers to entry, so there are no new entrants. Therefore, the unregulated monopoly produces profits in the long run. Copyright © 2014 CFA Institute

12 Identifying market structures
Methods of identifying market structures 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. Measures of concentration Concentration ratio Herfindahl–Hirschman Index (HHI) LOS: Identify the type of market structure a firm is operating within. Pages 188–191 There are two types of methods used to identify market structures. Econometric approaches estimate the elasticity of supply and demand (the more elastic, the more competitive) using either a time-series or a cross-sectional approach to examine the relationship between price and quantity. The second type is a measure of concentration, which includes the concentration ratio and Herfindahl–Hirschman Index (with larger values indicating more competitive). Notes to the presenter: The US FTC–DOJ merger guidelines and the EU Commission focus on the HHI to assess horizontal mergers. Copyright © 2014 CFA Institute

13 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 LOS: Describe the use and limitations of concentration measures in identifying the various forms of market structure. Pages 189–191 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. It ranges from 0 (perfect competition) to 100 (monopoly) and is easy to compute. The disadvantages are that it does not quantify market power, does not consider the ease of entry into the market, and is unaffected by mergers of the larger competitors. The HHI is the sum of the squared market shares of the top N companies. The higher the HHI, the more concentrated the industry. The HHI is easy to compute and is affected by mergers of the larger competitors. Its disadvantages are that it does not quantify market power and does not consider the ease of entry into the market. Notes to the presenter: A popular variant of the concentration ratio is the four-firm concentration ratio. A concentration ratio greater than 80% is high, 50%–80% is medium, and less than 50% is low concentration. US FTC–DOJ guidelines indicate that a market is considered concentrated if HHI is less than 1,500, modestly concentrated if between 1,500 and 2,500, and highly concentrated if above 2,500. Copyright © 2014 CFA Institute

14 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. Copyright © 2014 CFA Institute

15 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. Copyright © 2014 CFA Institute

16 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). Copyright © 2014 CFA Institute


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