SUMMARY: Industrial organization. Markets and strategies., Sintesi del corso di Economia Industriale

Scarica SUMMARY: Industrial organization. Markets and strategies. e più Sintesi del corso in PDF di Economia Industriale solo su Docsity! CHAPTER 10 MARKET STRUCTURE Focus on market structure: - firm size → how big are these firms. - concentration → how many firms are in the industry. If the two things coincide, all firms are identical. If all firms are identical, the concentration automatically gives also the market size. What determines market structure? ​Interesting question for basically all the players in an industry: - incumbent: ​what should I expect in the future? - potential entrant: ​what should I do? - analyst (government, antitrust authority): ​what should I do about entry? and is this concentration efficient or resulting from anti-competitive behaviour? (later in this course) Determinants of market structure: - technology; - market size; - mode of competition; - market power. Economic principle: market structure depends on many factors, but there are some regularities. Eg: Industry Concentration C4​: concentration index → is the sum ​S​i​ of market shares for the largest 4 firms in the industry. ​(45° line) The left panel in Figure 10.1 depicts data on market concentration (measured by C4, the total market share of the top four firms) in a number of sectors in France and in Germany. That is, for each sector, a point is marked such that the horizontal coordinate is the value of C4 in France and the vertical coordinate is the value of C4 in Germany. For example, if in a given sector the four largest French firms hold 40% of the market, whereas the four largest German firms hold 60% of the market, then a point (0.4,0.6) appears in the diagram. The right panel in Figure 10.1 represents a similar diagram, this time for France and Belgium. If the reality of the firm size distribution were as unpredictable as the model of perfect competition suggests, then we would expect the diagrams to be just a chaotic cloud of points. However, the first diagram shows a remarkable regularity, with most points close to the 45° line. In words, for each industry, the value of C4 in France is very similar to the value of C4 in Germany. This suggests that there are industry-specific factors which determine each firm's size. In contrast with the left panel in Figure 10.1, the right panel shows that most points are above the diagonal. In words, for each sector, the value of C4 tends to be greater in Belgium than in France. One important difference between the two panels is that, whereas the left panel refers to two economies of similar size (both in population and in GDP), the right panel compares two countries of very different size (France being some five times bigger than Belgium). Together, these diagrams suggest that market size, in addition to industry-specific factors, is an important determinant of market structure. MEASURING MARKET CONCENTRATION AND MARKET POWER In Chapter 8, I considered mostly symmetric oligopoly models. In this context, the number of firms,​ n,​ is a good indicator of industry structure: the lower ​n,​ the more concentrated the industry is. Specifically, ​1/n​ ​might be a good measure of concentration, a measure that varies from 0 (minimum concentration) and 1 (maximum concentration, monopoly). In practice, different firms have different market shares, and a simple firm count misses out important information regarding market structure and industry concentration. The more concentrated an industry, the lower is the number of firms. So a ​monopoly ​is an industry which has the maximum level of possible concentration. Concentration indexes ● → sum of market shares of largest ​m​ firms in the market. ​(Most used is C​4​ ​).Cm Cm = ∑ m i =1 si where firms are ordered by market shares (Firm 1 is the largest firm, and so on). The value of varies between zero (minimum concentration) and one (maximum concentration); orC4 between zero and 100, if we measure market share by percentage points (that is, from 0 to 100). ● Herfindal-Hirschmann index​ → ​sum of square values of market shares of all firms in the market. (sometimes referred to as the Herfindahl index, sometimes HHI, sometimes H),​ is given by: 2HIH = ∑ n i =1 (s )i The value of HHI varies between zero (minimum concentration) and one (maximum concentration, i.e., monopoly). If market shares are measured in percent points, then the value of HHI varies between zero and 10,000. The Herfindahl index provides a better measure of market concentration, however, it is more difficult to compute, because it is needed data of all firms in the market. We are also interested in measuring market power. Up to now, if all firms have the same costs, I did so by computing the price cost margin: either - p - MC - (p - MC)/p - (p - MC)/MC​. Market power index If costs vary from firm to firm, then so do margins (even if market price is the same for all firms, which is the case when the product is homogeneous). What is then market power in the industry as a whole? The natural generalization of the margin is the ​Lerner index​, defined as the weighted average of each firm's margin, with weights given by the firm's market share: L = ∑ n i =1 si p p − MC i where is firm 's market share.si i ● Equilibrium value of n︿ - increasing in ​a, S: The equilibrium number of firms increases as ​S​ increases: as​ n ︿ ↑ S ↑ The larger is the size of the market, the larger is the number of firms. Notice that the relation between and​ ​S​ is not linear, in the sense that there is the square root:n ︿ ● Relationship between ​S​ and ​n​ is increasing but less than proportional. ● Intuition:​ higher ​S​ leads to higher , but higher leads to lower​ p,​ which in turn limits the increase in .n n n → so, as the market size goes up, the number of firms in the market increases, though it does not increase linearly, but rather at a decreasing rate. What explains this non-proportional relationship between and​ ​S?n ︿ If market price were constant (with respect to the number of firms), then the relation between size and number of firms would be proportional: double market size and you double the number of firms. However, as the number of firms increases, the market becomes more competitive, that is, the margin ​p - c decreases. As a result, variable profit per unit of market size also decreases, which in turn limits the number of firms the market can sustain. Due to increased price competition, the equilibrium number of active firms varies less than proportionally with respect to market size . Role of technology As mentioned earlier, one of the determinants of market structure is the firm's cost structure. In particular, the fact that most firms have a U-shaped average cost curve is an important determinant of market structure. A firm in the left-hand side of the U, that is, a firm with decreasing average cost, is said to operate under increasing returns to scale​. (The model considered in this section, where costs are given by ​F + cq​, is an extreme case in which average cost is ​always decreasing​.) In order to measure the relation between increasing returns to scale and market structure, we first need to measure the degree of ​increasing returns to scale​. There are several ways of doing this. One is to use the concept of ​minimum efficient scale​, the minimum scale at which a firm's average cost is, say, within 10% of the minimum. In the model considered in this section, total cost is ​C = F + c q​. Average cost is therefore ​AC = F / q + c​. The minimum of average cost is ​c. Let the minimum efficient scale ​(MES)​ be the minimum scale such that average cost is equal to​ c'​. Equating ​AC = c' ​ and solving for ​q​, we get: .ES M = F(c − c)′ (slides) ● Equilibrium value of n ︿ - decreasing in ​F, c: The number of firms increases as fixed costs go down → lower F leads to high .n ● Relationship between ​F​ and ​c ​and concentration illustrated by two related concepts: - Minimum efficient scale; - Returns to scale. As varies, ​q​i​ ​varies.n So, the quantity that each firm produces depends on the number of firms operating in the industry. But what is the effect of this if the cost is given by this expression: ​C​i ​= F + c q​i​ ? If ​increases, the quantity produced by each firm goes down and the effect on total costs is a decrease.n → ​q​i → ​C n ↑ ↓ ↓ The variable cost of the firm goes up. Average costs are always decreasing. The larger is the firm operating in the industry, the more efficient is the firm. These are just illustrations of the fact that the number of firms operating in an industry, not only have an effect on quantity (that is on the demand size), but also on the technology, in particular on the efficiency of the firms. Do you remember how we defined the technology such that efficiency varies with the quantity produced by the firm, remember which concept we normally use? Economies of scale (returns to scale). C = cq + F ​→ this is a very special technology such that there are always economies of scale. We normally have a situation like the little graph above, but in this case instead AC are always decreasing. So the larger is the firm operating in the industry, the more efficient is the firm. So this is a case in which firms always enjoy economies of scale. However, there may be situations like in standard cases​ (graph above). This is what we call a ​minimum efficient scale​ → is when each firm produces at the minimum of the average cost. This is very much linked to the idea of ​zero profit equilibrium​: if this is the price and this is the quantity that the firm produces it gets 0 profit. If the fixed costs are higher, what happens to this picture? So again, this is an example of illustration of how the number of firms operating in an industry are linked to the technology and how the idea of the minimum efficient scale, which is this particular case or the idea of return to scale is very important in determining the number of firms. Going back to the idea of returns to scale → imagine what would happen if there were more firms operating in the industry, so that each firm had to produce this quantity here ​(in blue). If each firm had to produce this quantity, a reduction of the number of firms would be beneficial because each firm would produce at a lower cost by producing more ​(because of the exiting out of the market by firms). So far we have been able to see how in a very special model the industry concentration ​(the number of firms in an industry)​ is related to the size of the markets and the nature of the technology. In particular, - the larger the size of the market, the higher is the number of firms which may be accommodated in this market, ​and - the larger the fixed cost, the lower is the number of firms which can stay in this markets making non-negative profits. And we also saw that these fixed costs are just one illustration of a more complicated concept of the firm's technology, that is in particular their returns to scale of this technology and their return to scale it determines what is the minimum efficient scale, which is the the quantity the firms should produce to be able to reach the minimum of the average cost. Concentration is generally greater the greater the minimum efficient scale (or the greater the degree of scale economies). Both the minimum efficient scale and economies of scale are instances of ​barriers to entry. A generalization of the above point is therefore that concentration is greater the higher the barriers to entry are. History matters (slides) At the beginning: a lot of new entrants. After a while: some firms started to exit the market. Mid ‘80s up to ‘90s: reached a sort of a plateau. Then → (as in many other new industries), we observe that when technology and demand consolidate, there is a sharp reduction in the number of firms. So most firms got out of the market, there were a few entrances, but most firms were simply exiting the market. So between 1990 and 2000 the number of firms dropped from 30 to around 10. And the interesting thing is that this first wave of reduction was motivated mostly by ​bankruptcy​ or by liquidation​. So firms were actually exiting the market, but there is a last more recent wave of consolidation which occurs from year 2000 to basically to now, which has reduced further the number of firms from 9 and now there are basically only 3 producers across the world of hard drive disk, and the interesting bit is that this second wave of reduction occurred because the 6 firms which are now currently missing disappeared because they have been acquired or they merged into other firms which are still operating in the market. This is a very good illustration of how the dynamic process of determination of the industry equilibrium occurs not only between a standard process of entering and exiting the market but also between by means of consolidations across firms, that is either mergers or acquisitions (M&A). 10.2 ENDOGENOUS VS. EXOGENOUS ENTRY COSTS C​i ​= F + c q​i Something very interesting is our leading formula in a sense → this was the formula that we are using for analyzing the determinants of market concentration. We have that Fixed Costs, which are basically the fixed cost that the firm has to bear even when producing nothing, are exogenously determined, so this is something coming from the technology, is given by the technology, no one can change this. Look at this example. The basic idea is that if that formula were valid, we would see that the number of firms in a small country like Portugal should be related to the size of this country, especially as opposed to the U.S. So, let's imagine that in this industry the number of firms in the U.S. is determined by our leading formula where ​S​ is the size of the US market. Size of the US market → GDP is the size of the U.S. is about 50 times larger than the size of Portugal (S= 1). So we could basically substitute the ​S​ of the size of U.S. as 50 times the size of Portugal and this basically would give us that the number of firms operating in Portugal in these industries are related by this factor to the number of firms operating in the US. So in a sense we would expect a much smaller number of firms in Portugal than we observe in the US. Some industries, like the beer industry, deny this completely. And in particular we observed that the number of beer producers in Portugal is equal to 2, while the number of beer producers in the U.S. is equal to 3 ​(we are talking about large producers). This contradicts completely our prediction. What's wrong with this? What is the problem in our model? The problem in our model is in taking [​C​ ​= F + c q​i ​]​ ​→ this as our leading technology and in particular in imagining that the fixed costs are given. In many industries fixed costs are not given and this is particularly the case of the beer industry. In the beer industry we have one fixed cost [​F​ ​] which is not given and it is not identical for firms operating in Portugal and for firms operating in the U.S. and this cost is​ Advertising. Endogenous entry costs ● Much of the entry cost into (national brand) beer is ​advertising​. ● Advertising expenditures are roughly proportional to sales (when comparing various countries). ● Hence, as ​S​ increases, so does ​F. ● In the limit, if ​F​ is proportional to ​S​, then remains flat w.r.t. ​S​.n︿ So our beer producers both in Portugal and in the U.S., to be able to produce, they need to spend a lot of money which is completely unrelated to the quantity that they produce so in this sense we have what we can call this a fixed cost ​[​ ​C = cq + F​ ​]​ because it's not related to production. But the interesting bit is that we observed data for beer producers basically all over the world and we observe that advertising expenditure is roughly proportional to sales. So what we observe is that the fixed cost of a U.S., if it is true that the size of the U.S. is approximately 50 times the size of Portugal, it is also true that the fixed cost of the U.S. producers is approximately as large as 50 times the fixed cost of Portugal beer producers. If we had these endogenous fixed cost and if fixed cost are not only given by the technology, but are also an important determinant of the production technology, but they depend also on other issues that the technology in this particular case, they depend on the needs of continuously advertising products. So these fixed costs would be varying across countries and they would affect our picture, and indeed if ​F​ is perfectly proportional to the size of the market, we have that the number of firms basically does not depend on ​S​ because if ​F​ ​(like in here)​ is proportional to the size of the market, what we observe is that​ does notn︿ depend anymore on the size of the market. One important reason why our analysis tells us only a part of the story is because not only history matters, but also because the technology is not as given as one would expect. And there are some industries, there are some costs which cannot be deemed to be exogenous, but are strongly dependent on the size of the market in which the firm operates. Basically notice not the quantity produced (which otherwise would be a non-fixed cost) but the size of the market and the number of consumers you need to reach to make sure that some of that will buy your beer. And the same basically applies for lots of commodities for which we observe a lot of advertising. In other words, when advertising is an important part of a firm's strategy, entry costs are endogenous, specifically, endogenous with respect to market size. The comparative statics of industries with endogenous entry costs are somewhat different from the model in the previous section. The idea of the model in the previous section is that, because of price competition, as market size increases by a factor of two there will be room for less than twice as many firms. (In the specific case of Cournot competition, the number of firms can only increase by the square root of two as market size doubles.) If entry costs are increasing in market size, then we have an additional reason whereby the number of firms does not increase as much as market size. A bigger market induces firms to make bigger investments. Since these investments are costly, the net "pie" in terms of industry profits grows by less than market size. As a result, even if competition were not to increase (as in the previous section), the number of firms would increase by less than market size. If entry costs are endogenous, then the number of firms is less sensitive to changes in market size. 10.4 ENTRY AND WELFARE The model of perfect competition shows that, if there is free entry and if a number of other conditions are satisfied, then the equilibrium is socially efficient. If all of the other conditions are satisfied, then absence of free entry (e.g., barriers to entry) implies inefficiency. However, if the other conditions of the perfect competition model fail (e.g., price-taking behavior fails), then it is no longer necessarily the case that free entry is desirable from the perspective of economic efficiency. This point is illustrated in Figure 10.4, which depicts an industry with aggregate marginal cost MC and demand ​D(p). Suppose first that there are n active firms, producing a total output ​Q​n​ ​which is sold at price ​P​n​. Suppose now that an extra firm enters the industry. The output produced by the entrant is ​q​n+1 ​, whereas total output is now given by ​Q​n+1​ and price by ​P​n+1​. The change in gross surplus (not including entry costs) is given by areas B plus C. The gross profit earned by the new entrant is given by areas A plus B (assuming the entrant has the highest marginal cost of all firms). The way the figure is drawn, the increase in gross surplus (area B plus C) is smaller than the gross profit earned by the latest entrant (area A +B). This implies an important potential divergence between the private and the social incentives for entry by the n + 1st firm. Suppose that the entry cost, E, is such that B + C < E <A+ B. Then entry is profitable from a private perspective (positive net profits) but not from a social perspective (the increase in gross surplus does not compensate for the entry cost). In this circumstance, ​free entry results in excessive entry​. What is the reason for this divergence between private and social entry incentives? The key is that part of the profits earned by the entrant are "stolen" from the incumbent firms. Area A measures (approximately) this ​business stealing effect​, ​a transfer between firms which does not correspond to a benefit to society (although obviously it benefits the entrant). Retail banking is one example where the above argument might be applied. In some European countries, due to regulation or lack of competition, margins can at times be very high (cf also the example of Kenya, referred to in the previous section). Moreover, given the relative homogeneity of retail banking services and the low elasticity of demand, it is likely that the business-stealing effect is significant. For this reason, one would expect the equilibrium number of banks and bank branches to be excessive from a social point of view. In Portugal, in the late 1980s and for a period of time, banks were required to pay a fee in order to open a new branch. While there were different political motives underlying this measure, one possible defense in terms of economic efficiency is precisely the business stealing entry externality. Another example is given by broadcast radio. In the US and in other countries, a large fraction of radio stations are thematic, that is, devoted to a particular type of music (or to talk shows). Empirical evidence suggests that the main effect of opening a new station is to divert listeners from other stations. As a result, the market equilibrium features too many rock stations, to the detriment of other genres such as classical music. Still another example is given by real estate services in the US. Typically, brokers charge a 6°/o commission regardless of the price of the house sold. In other words, there is very little price competition, which implies that any profit opportunity is taken up in the form of additional entry. Empirical evidence shows that, when housing prices in a given city increase, more real-estate brokers enter the local market, which in turn leads to a drop in the number of houses sold per agent. However, the average real wage of brokers remains constant, that is, the increase in commissions exactly compensates for the decrease in the number of clients. This is consistent with the idea that there is excessive entry in these markets: all that new entry is doing is competing away existing rents; that is, the business stealing effect dominates. PRODUCT DIFFERENTIATION, FREE ENTRY, AND EFFICIENCY The result of excessive entry is subject to an important qualification: if there is product differentiation, then entry implies, in addition to a decrease in price, an increase in product variety. The entrant is normally unable to capture all of the additional willingness to pay generated by the new product. That is to say, there is a positive externality from entrant to consumers. For example, if a new car firm enters the industry with an innovative car design, many consumers will be willing to pay more for the new car than it will be priced. In other words, some of the benefits from the new car design are not captured by its designer. If product differentiation is very important, or if competition is very fierce, then free entry implies insufficient entry from a social point of view. Conversely, if product differentiation is unimportant and competition is soft, then the business-stealing effect dominates, whereby the free-entry equilibrium entails excessive entry. FIRM HETEROGENEITY, FREE ENTRY, AND EFFICIENCY Another qualification on the excessive entry result is that it does not focus on efficiency differences across firms. Empirical evidence shows that there is significant firm turnover in most industries, with lower productivity firms being replaced by higher productivity ones. In this context, a ​dynamic ​analysis of free entry should take into account the benefits from entry in terms of increased average productivity. Firm entry and exit, as well as the reallocation of capital among incumbents, is an important component of industry productivity growth. ​(slides) Free entry and welfare ★ Suppose number of (identical) firms increases from ​n ​ to ​n​ ​+​ ​1 ★ Price drops from​ ​p ​n​ ​to​ ​p ​n+1 Total output increases from ​nq​n​ to ​(​ ​n ​ ​+​ ​1)q​n+1 The increase in total output is due to: - the increase in the number of firms ​n ​; - a change in the output of each firm ​(q ​n​ ,​ q ​n+1​ ​)​. ★ Impact of entry in social welfare ⊳ Consumer surplus increases by approx: ​ ½ ​( ​p​n​ ​-​ ​p​n+1​ )(​Q​n+1​ ​- ​Q​n​ ) ⊳ Entrant gains: π​n+1​− E we expect it to be positive, because otherwise enter wouldn’t have occurred. It is given by the profits that the firm obtains (​π​n+1​) minus the entry costs of this firm. Notice that in both cases above, in the presence of an entry the effect of welfare is positive, but incumbent firms (below) have a negative effect. ⊳ Incumbent firms lose: ​n​ ​(π ​n+1​− π ​n​ ​) Negative effect→ for the fact that the profit that they obtain with n + 1 firms is smaller than the profits that they obtain when they are only n firms in the market. This loss of profits occurs not only for the one firm which enters the market, but for the n firms which were already in the market, the so-called incumbents. Overall we cannot argue that for sure entry leads to an increase in social welfare. Some of the players in this market may lose. ★ Presumably, if entry takes place, then ​π​n+1​ − E > 0​ ​. ● Business stealing effect​: part of the entrant’s variable profit (area A) is a transfer from incumbents. ● Negative entry externality: A is a gain for entrant but not a gain for society as a whole. ● Consumer surplus effect​: entry implies an increase in consumer surplus (area C) that is not captured by firms​. ● Positive entry externality: C is a gain for society as a whole gain but not for entrant. ● If A > C, free entry ⇒ excess entry. If A < C, free entry ⇒ insufficient entry. Firm turnover and allocative efficiency Above analysis assumes identical firms and focuses on ​allocative efficiency​ (how much to produce). If different firms have different costs, selecting the lowest cost firms improves ​productive efficiency​ (lower total costs). Additional benefit from entry and exit: selection and asset reallocation. - Lower cost firms enter, higher cost firms exit (extensive margin). - Among incumbents, lower cost firms have higher output (intensive margin).