#cfa-level-1 #microeconomics #reading-16-the-firm-and-market-structures #section-2-analysis-of-mkt-structures #study-session-4
Traditionally, economists classify a market into one of four structures: perfect competition, monopolistic competition, oligopoly, and monopoly. Section 2.1 explains that four-way classification in more detail. Section 2.2 completes the introduction by providing and explaining the major points to evaluate in determining the structure to which a market belongs.
Economists define a market as a group of buyers and sellers that are aware of each other and are able to agree on a price for the exchange of goods and services. While the internet has extended a number of markets worldwide, certain markets are limited by geographic boundaries. For example, the internet search engine Google operates in a worldwide market. In contrast, the market for premixed cement is limited to the area within which a truck can deliver the mushy mix from the plant to a construction site before the compound becomes useless. Thomas L. Friedman’s international best seller The World Is Flat1 challenges the concept of the geographic limitations of the market. If the service being provided by the seller can be digitized, its market expands worldwide. For example, a technician can scan your injury in a clinic in Switzerland. That radiographic image can be digitized and sent to a radiologist in India to be read. As a customer (i.e., patient), you may never know that part of the medical service provided to you was the result of a worldwide market.
Some markets are highly concentrated, with the majority of total sales coming from a small number of firms. For example, in the market for small consumer batteries, three firms controlled 87 percent of the US market (Duracell 43 percent, Energizer 33 percent, and Rayovac 11 percent) as of 2005. Other markets are very fragmented, such as automobile repairs, where small independent shops often dominate and large chains may or may not exist. New products can lead to market concentration: It is estimated that the Apple iPod had a world market share of over 70 percent among MP3 players in 2009.THE IMPORTANCE OF MARKET STRUCTURE
Consider the evolution of television broadcasting. As the market environment for television broadcasting evolved, the market structure changed, resulting in a new set of challenges and choices. In the early days, there was only one choice: the “free” analog channels that were broadcast over the airwaves. In most countries, there was only one channel, owned and run by the government. In the United States, some of the more populated markets were able to receive more channels because local channels were set up to cover a market with more potential viewers. By the 1970s, new technologies made it possible to broadcast by way of cable connectivity and the choices offered to consumers began to expand rapidly. Cable television challenged the “free” broadcast channels by offering more choice and a better-quality picture. The innovation was expensive for consumers and profitable for the cable companies. By the 1990s, a new alternative began to challenge the existing broadcast and cable systems: satellite television. Satellite providers offered a further expanded set of choices, albeit at a higher price than the free broadcast and cable alternatives. In the early 2000s, satellite television providers lowered their pricing to compete directly with the cable providers. Today, cable program providers, satellite television providers, and terrestrial digital broadcasters that offer premium and pay-per-view channels compete for customers who are increasingly finding content on the internet.
This is a simple illustration of the importance of market structure. As the market for television broadcasting became increasingly competitive, managers had to make decisions regarding product packaging, pricing, advertising, and marketing in order to survive in the changing environment.
Market structure can be broken down into four distinct categories: perfect competition, monopolistic competition, oligopoly, and monopoly.
We start with the most competitive environment, perfect competition. Unlike some economic concepts, perfect competition is not merely an ideal based on assumptions. Perfect competition is a reality—for example, in several commodities markets, where sellers and buyers have a strictly homogeneous product and no single producer is large enough to influence market prices. Perfect competition’s characteristics are well recognized and its long-run outcome unavoidable. Profits under the conditions of perfect competition are driven to the required rate of return paid by the entrepreneur to borrow capital from investors (so-called normal profit or rental cost of capital). This does not mean that all perfectly competitive industries are doomed to extinction by a lack of profits. On the contrary, millions of businesses that do very well are living under the pressures of perfect competition.
Monopolistic competition is also highly competitive; however, it is considered a form of imperfect competition. Two economists, Edward H. Chamberlin (US) and Joan Robinson (UK), identified this hybrid market and came up with the term because there are strong elements of competition in this market structure and also some monopoly-like conditions. The competitive characteristic is a notably large number of firms, while the monopoly aspect is the result of product differentiation. That is, if the seller can convince consumers that its product is uniquely different from other, similar products, then the seller can exercise some degree of pricing power over the market. A good example is the brand loyalty associated with soft drinks such as Coca-Cola. Many of Coca-Cola’s customers believe that their beverages are truly different from and better than all other soft drinks. The same is true for fashion creations and cosmetics.
The oligopoly market structure is based on a relatively small number of firms supplying the market. The small number of firms in the market means that each firm must consider what retaliatory strategies the other firms will pursue when prices and production levels change. Consider the pricing behavior of commercial airline companies. Pricing strategies and route scheduling are based on the expected reaction of the other carriers in similar markets. For any given route—say, from Paris, France, to Chennai, India—only a few carriers are in competition. If one of the carriers changes its pricing package, others will likely retaliate. Understanding the market structure of oligopoly markets can help in identifying a logical pattern of strategic price changes for the competing firms.
Finally, the least competitive market structure is monopoly. In pure monopoly markets, there are no other good substitutes for the given product or service. There is a single seller, which, if allowed to operate without constraint, exercises considerable power over pricing and output decisions. In most market-based economies around the globe, pure monopolies are regulated by a governmental authority. The most common example of a regulated monopoly is the local electrical power provider. In most cases, the monopoly power provider is allowed to earn a normal return on its investment and prices are set by the regulatory authority to allow that return.
Five factors determine market structure:
The number and relative size of firms supplying the product;
The degree of product differentiation;
The power of the seller over pricing decisions;
The relative strength of the barriers to market entry and exit; and
The degree of non-price competition.
The number and relative size of firms in a market influence market structure. If there are many firms, the degree of competition increases. With fewer firms supplying a good or service, consumers are limited in their market choices. One extreme case is the monopoly market structure, with only one firm supplying a unique good or service. Another extreme is perfect competition, with many firms supplying a similar product. Finally, an example of relative size is the automobile industry, in which a small number of large international producers (e.g., Ford and Toyota) are the leaders in the global market, and a number of small companies either have market power because they are niche players (e.g., Ferrari) or have little market power because of their narrow range of models or limited geographical presence (e.g., Škoda).
In the case of monopolistic competition, there are many firms providing products to the market, as with perfect competition. However, one firm’s product is differentiated in some way that makes it appear better than similar products from other firms. If a firm is successful in differentiating its product, the differentiation will provide pricing leverage. The more dissimilar the product appears, the more the market will resemble the monopoly market structure. A firm can differentiate its product through aggressive advertising campaigns; frequent styling changes; the linking of its product with other, complementary products; or a host of other methods.
When the market dictates the price based on aggregate supply and demand conditions, the individual firm has no control over pricing. The typical hog farmer in Nebraska and the milk producer in Bavaria are price takers. That is, they must accept whatever price the market dictates. This is the case under the market structure of perfect competition. In the case of monopolistic competition, the success of product differentiation determines the degree with which the firm can influence price. In the case of oligopoly, there are so few firms in the market that price control becomes possible. However, the small number of firms in an oligopoly market invites complex pricing strategies. Collusion, price leadership by dominant firms, and other pricing strategies can result.
The degree to which one market structure can evolve into another and the difference between potential short-run outcomes and long-run equilibrium conditions depend on the strength of the barriers to entry and the possibility that firms fail to recoup their original costs or lose money for an extended period of time and are therefore forced to exit the market. Barriers to entry can result from very large capital investment requirements, as in the case of petroleum refining. Barriers may also result from patents, as in the case of some electronic products and drug formulas. Another entry consideration is the possibility of high exit costs. For example, plants that are specific to a special line of products, such as aluminum smelting plants, are non-redeployable, and exit costs would be high without a liquid market for the firm’s assets. High exit costs deter entry and are therefore also considered barriers to entry. In the case of farming, the barriers to entry are low. Production of corn, soybeans, wheat, tomatoes, and other produce is an easy process to replicate; therefore, those are highly competitive markets.
Non-price competition dominates those market structures where product differentiation is critical. Therefore, monopolistic competition relies on competitive strategies that may not include pricing changes. An example of non-price competition is product differentiation through marketing. In other circumstances, non-price competition may occur because the few firms in the market feel dependent on each other. Each firm fears retaliatory price changes that would reduce total revenue for all of the firms in the market. Because oligopoly industries have so few firms, each firm feels dependent on the pricing strategies of the others. Therefore, non-price competition becomes a dominant strategy.Exhibit 1. Characteristics of Market Structure
|Market Structure||Number of Sellers||Degree of Product Differentiation||Barriers to Entry||Pricing Power of Firm||Non-price 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|
From the perspective of the owners of the firm, the most desirable market structure is that with the most control over price, because this control can lead to large profits. Monopoly and oligopoly markets offer the greatest potential control over price; monopolistic competition offers less control. Firms operating under perfectly competitive market conditions have no control over price. From the consumers’ perspective, the most desirable market structure is that with the greatest degree of competition, because prices are generally lower. Thus, consumers would prefer as many goods and services as possible to be offered in competitive markets.
As often happens in economics, there is a trade-off. While perfect competition gives the largest quantity of a good at the lowest price, other market forms may spur more innovation. Specifically, there may be high costs in researching a new product, and firms will incur such costs only if they expect to earn an attractive return on their research investment. This is the case often made for medical innovations, for example—the cost of clinical trials and experiments to create new medicines would bankrupt perfectly competitive firms but may be acceptable in an oligopoly market structure. Therefore, consumers can benefit from less-than-perfectly-competitive markets.PORTER’S FIVE FORCES AND MARKET STRUCTURE
A financial analyst aiming to establish market conditions and consequent profitability of incumbent firms should start with the questions framed by Exhibit 1: How many sellers are there? Is the product differentiated? and so on. Moreover, in the case of monopolies and quasi monopolies, the analyst should evaluate the legislative and regulatory framework: Can the company set prices freely, or are there governmental controls? Finally, the analyst should consider the threat of competition from potential entrants.
This analysis is often summarized by students of corporate strategy as “Porter’s five forces,” named after Harvard Business School professor Michael E. Porter. His book, Competitive Strategy, presented a systematic analysis of the practice of market strategy. Porter (2008) identified the five forces as:
Threat of entry;
Power of suppliers;
Power of buyers (customers);
Threat of substitutes; and
Rivalry among existing competitors.
It is easy to note the parallels between four of these five forces and the columns in Exhibit 1. The only “orphan” is the power of suppliers, which is not at the core of the theoretical economic analysis of competition, but which has substantial weight in the practical analysis of competition and profitability.
Some stock analysts (e.g., Dorsey 2004) use the term “economic moat” to suggest that there are factors protecting the profitability of a firm that are similar to the moats (ditches full of water) that used to protect some medieval castles. A deep moat means that there is little or no threat of entry by invaders, i.e. competitors. It also means that customers are locked in because of high switching costs.