Market Structure Conduct and Performance

Revising for A2 Economics Questions on Markets

What is market structure?

• Organisational characteristics of a market

• We usually focus on those characteristics of a market which affect the degree of competition between firms + their pricing decisions

• Traditionally we emphasise:

1. The number and size distribution of buyers and sellers

2. The existence or absence of barriers to entry and exit

Structural characteristics of a market

• Ownership structure (e.g. state or private sector)

• Market share of largest businesses (concentration ratio)

• Nature of costs in the short & long run

• Degree of vertical integration along the supply chain

• Extent of product differentiation / product branding

• Price (Ped) and cross (Xed) price elasticity of demand

• Number and size of buyers of the industry’s product

• Turnover of customers from one seller to another (called “market churn”) – affected by brand loyalty and advertising and marketing

Q3Q2Q1

Cost & Price

Output (Q)

Costs and contestability in different industries

Low MES, limited scale economies, contestable market

LRAC

Q1 Output (Q)

High MES, falling LRAC, barriers to contestability

Extensive internal economies of scale leading to lower LRAC

Extensive internal economies of scale leading to lower LRAC

LRAC

Minimum efficient scale (MES)

Minimum efficient scale (MES)

Q4

AverageCost perUnit (£)

Quantity of output (Q)

Long Run Average Cost for a Natural Monopoly

Average cost falls across a large range of output – due to increasing returns

to scale

Average cost falls across a large range of output – due to increasing returns

to scale

Long run marginal cost of production is often low and stable as output

changes

Long run marginal cost of production is often low and stable as output

changes

LRACLRMC

AC1

AC2

AC3

Q1 Q2 Q3

Importance of defining the market

• Market and the industry often used inter-changeably

• But……………………………

– If we define a market in a narrow sense, it is likely that there will be fewer producers

• E.g. the market for air travel to Aberdeen

– A broader definition of the market often gives us more choice

• E.g. the air transport industry (low cost airlines)

• The market for sportswear

– Defining the market is important when we measure the concentration ratio and the extent to which a market is dominated by one or a few large producers

Market Share and Market Power

Market share is not the same as market power!

First-Mover Advantages for Apple?

The Nature of Costs in an Industry

• Entry costs into a market

– Capital costs will vary from industry to industry

– E.g. a natural monopoly such as energy and power networks

• Sunk costs / exit costs

– These are costs that are not recoverable if a business leaves

• E.g. advertising and marketing

• Depreciation of capital equipment

– High sunk costs makes a market less contestable

• Natural cost advantages

– Location advantages e.g. close to ports, access to cheaper labour

– Ownership of important raw materials

– Control of the supply chain through vertical integration

Product differentiation

• Homogeneous goods– Essentially the same physical characteristics– Associated with perfect competition– Different grades e.g. steel, cement, coal, fresh fruit

• Non-homogeneous goods– Products differentiated from their competitors– Branding, packaging and marketing are key here

• Strong product differentiation and brand loyalty allows firms to charge higher premium prices– Demand become less price elastic– Reduction in the cross-price elasticity of demand– Higher profit margins for a given unit cost

Conduct / Behaviour of Firms

• How does market structure affect pricing, output and other decisions of businesses within the market

• Are there dominant firms?

• Is there evidence of anti-competitive behaviour?

– Collusive pricing agreements

– Control over the supply chain?

• How important is non-price competition in the market?

• Is there interdependence between firms?

• Do businesses behave strategically to retain profits by deterring the entry of new competitors in the long run?

• Be aware that the market structure will affect the behaviour of firms

Some Key Performance Indicators

• Trends in real price levels for consumers over time

• Size of business profits – evidence of excess (monopoly) profits?

• How much spending on research and development and innovation

• Trend changes in labour productivity (output per worker employed)

• Environmental indicators e.g. Progress in reducing carbon intensity

• Does the conduct of firms give rise to efficient outcomes?

1. Allocative efficiency (prices relative to marginal cost)

2. Productive efficiency (unit costs in short and long run)

3. Dynamic efficiency (pace of innovation, quality of product)

4. Social efficiency (accounting for externalities)

Economic Efficiency Matters!

Cost & Price

Output (Q)

Allocative Efficiency – Competition / Pure Monopoly

Cost & Price

Output (Q)

Perfectly Competitive Market Pure Monopoly Market

S1

D1

P1

P2

Entry of new firms

drives price lower

Entry of new firms

drives price lower

AC

MC

AC

MC

Monopoly demand

(AR)MR

P1 P1

Q1 Q2

P2

C2

Monopoly ProfitP>MCLoss of allocative efficiency

Monopoly ProfitP>MCLoss of allocative efficiency

S2

The usual causal view

Market structureMarket structure

Conduct of Firms

Conduct of Firms PerformancePerformance

Conduct and market structure

The conduct of firms in a market can affect market structure – e.g. merger and takeover activity

Market structureMarket structure

Conduct of Firms

Conduct of Firms PerformancePerformance

Performance and changing markets

The actual performance of firms in the market affects market structure – e.g. rising dominance of best performing businesses – examples: pharmaceuticals, food retailing

Market structureMarket structure

Conduct of Firms

Conduct of Firms PerformancePerformance

Performance can affect market structure

• Performance can affect structure

– Top performing firms will gain market share at expense of rivals

– This gives them more market power

– Fine line between market dominance and economic efficiency

• Market conduct affects structure

– E.g. decisions about research and development and marketing

• Strategic behaviour of firms especially in oligopoly makes it difficult to rely on the structure conduct performance model

• The theory of contestable markets stresses the dynamic nature of competition especially when a market is open

Market power is often self-reinforcing

Innovative businesses can disrupt dominance

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