ABSE 203Competition in the Industry

ABSE 203Competition in the Industry

1. Definition of the industry

Definition of the industry is one of the most important issues not only in economic theory, but for any producer and buyer. In order to make market decisions every producer should have a very clear picture of its competitors. On the other side of the market, buyers will be happy to have full information about the opportunities offered by all firms producing the good that they are interested in purchasing.

The industry is a group of firms selling in the same market and to the same buyer.

This definition means that:

• the buyer considers the products sold by the firms in the industry as substitutes.
• The behavior of firms in the industry depends on their number and on the substitutability of the product.

Therefore, in order to study competition in the industry, we should identify the structure of the industry.

1. Structure of the industry (Market structure) – Conduct - Performance

The market structure is presented by the following features of the industry:

• number and size of sellers and buyers;

For example, there are industries with many small sellers like retail trade. The sellers of groceries in a town are numerous and everyone of them has a very small market share. On the other hand, internet services are offered just by a few firms in Cyprus. Electricity is sold by only one firm.

• degree of homogeneity and differentiation of the product;

A product is homogeneous if buyers do not find a difference between the products (services) sold by different firms to satisfy a particular need. The product is differentiated if buyers believe that different sellers would satisfy his/her needs to a different extent and in a different way.

For example, people who have lived in Limassol for years have their favorite cafeterias and restaurants and they believe that they are better than any others. For them, services offered by their cafeteria or restaurant are different. This service is differentiated. On the other hand, if you do not make any difference between sugar sold by one firm or by another one, sugar is a homogeneous product for you.

• The existence or nonexistence of barriers to entry to and/or exit from the industry;

Barriers to entry are factors or circumstances that demotivate newcomers to enter the industry and compete with the incumbent firms. For example, economies of scale are such a factor that would prevent new firms to enter the oil refinery industry. Small firms would have very high costs compared to the incumbent firms, while big firms would supply large quantities that would reduce the price significantly and ruin the market.

Barriers to exit are factors that keep the firms in the industry if even they are earning zero or negative profits. At the moment there are some developers that do not leave the business just because they have invested too much in construction and shutting down would ruin them.

• Thedegreeof transparency of information in the industry.

Information is transparent if all participants in the market get the same story from market signals.

The market structure determines firms’ conduct and performance.

Firms’ conduct presents the decisions concerning market variables and policies reflecting the behavior of competitors. In other words, firms’ conduct reflects pricing decisions, product development, advertisement, contracts, etc.

Industry’s performance is determined by the market structure and firms’ conduct. It is an assessment of the efficiency of competition in the industry. In other words, it presents the outcomes of competitions from the perspective of the efficient solution of the three economic problems.

According to the determinants of the market structure, economists identify four typical types of competition:

• Perfect competition;
• Pure monopoly;
• Monopolistic competition;
• Oligopoly.

1. Market structure under perfect competition

The industry is identified as a perfectly competitive if:

a)there are many and small seller (and buyers).

b)The product is homogeneous

c)There are no barriers to entry to and exit from the industry

d)Information is completely transparent.

The first feature of perfect competition means that sellers are that many and that small, that no one of them can influence the industry market. For example, if one of the many small sellers of lemons in the open market would reduce the price of the lemons, his competitors would not consider this as a threat for their business, because he does not have the capacity to “steal” their customers. He is too small to serve all buyers and the other sellers will not follow him and reduce the price too. Therefore, he cannot affect the market price. If he decides to raise the price, most of his customers will leave him and buy from the competitors (do not forget that under perfect competition the product is homogeneous and buyers do not see any difference between the sellers and their products). In this case, again, the single firm that raises the price of its products, cannot affect the market price. Since perfect competitors are very small, they cannot affect the supply of the good if they raise their own supply, or if they reduce it and if even they leave the market. Their market share is too small (say, it is 0.000001 of the entire market) to shift the supply curve. This is why we say, that perfect competitors are price-takers. They take the price from the market and they cannot set the market price on their own.

The second feature of perfect competition means that buyers consider products sold by the firms in the industry as perfect substitutes. This is why no firm can affect the market price.

The third feature of perfect competition means that any firm can enter the industry, and the incumbent firms do not have any advantages as compared to the newcomers. On the other hand, if a firm decides to leave the industry, it can easily sell its business for what it is worth and leave it with no losses.

Perfectly transparent information means that market signals tell the same story to all participants in the market and no one has any information advantages.

1. Market structure under the pure monopoly

The pure monopoly is a market structure with the following features:

1. There is only one seller in the industry;
2. The product does not have close substitutes;
3. The entry to and exit from the industry are blocked.

Theseconditions define the pure monopoly as an extreme market structure, which can be found just in a few industries. The condition for the unique product means that buyers cannot shift their demand to a supplier of a substitute.

A typical example for a pure monopoly is the water supply company in a city. It exists because the market for the service is relatively small and limited within the city. Of course, citizens of Limassol have an option to become clients of Pafos’ water supply company, but this would be involve building all the facilities that would bring water from Pafos, that the price of the service would be prohibitive. In other words, the pure monopoly in water supply in Limassol is determined by the specific production conditions in this industry.

Types of monopoly: natural and institutional monopoly

Monopoly could exist due to objective factors, or it could be deliberately created by economic decision makers.

The former is a natural monopoly, and the latter is an institutional monopoly.

A natural monopoly can exist in three cases:

- the monopolist can possess resources, which could not be replicated by anyone else.

A good example is the ability of an artist to create unique art. Another example is the possession of mineral deposits.

- economies of scale are achieved in the industry at a very large output, which makes competition meaningless.

Fig. 1. Economies of scale

Technological changes can eliminate the grounds for such a natural monopoly. A good example is the production of steel. A natural monopoly existed in this industry due to economies of scale up to the mid-1980s. Then, plastics were created as a substitute for traditional steel, and the demand shifted to plastics and to specialized steel, which could be produced cheaper in mini mills.

-local monopoly exists when the local market is too small and does not justify operation of many producers (like the water supply company).

Technological progress can shape new demand and eliminate local monopoly, as well. This is why the Nobel prize winner Garry Becker wrote that “there is nothing natural in natural monopoly”.

Institutional monopoly is created deliberately by firms or government. It might exist due to the following reasons:

a merger or a collusion in the industry (for example a few big firms in the industry coordinate their pricing and product policies in order to reap higher profits);

-government procurement or regulation (government can give an exclusive license to a particular firm to produce a specific product, or set high tariffs on imports and thus preserve the market for the local producer);

-government monopoly (only a government owned firm is allowed to produce in an industry)

Trade liberalization and deregulation can eliminate institutional monopoly.

1. Market structure under monopolistic competition

Monopolistic competition is “the first cousin” of perfect competition. It differs from perfect competition just in one condition – the type of the product. The features of monopolistic competition are the following:

a) There are many and small seller (and buyers).

b) The product is differentiated

c) There are no barriers to entry to and exit from the industry

d) Information is completely transparent.

Monopolistic competition is typical in retail trade, in restaurant business and many services.

1. Market structure under oligopoly

Oligopoly is the most common market structure and the most complicated.

a)there are two types of oligopoly, according to the first condition for market structure

-tight oligopoly – there are a few large firms in the industry with comparable market shares (often seen in cement industry, automobile, and metal production)

-dominant firm oligopoly – there a few large firms in the industry but one of them is recognized by the others as a leader and they follow its moves. On the other hand, the leader is responsible for the stability in the industry (often seen in the financial sector)

b)according to the type of the product, we find two types of oligopoly, again

-homogeneous oligopoly (the product is homogeneous – cement production, sugar production)

-heterogeneous oligopoly (the product is differentiated – automobile production, detergents, etc.)

c)there are significant barriers to entry to the industry

Barriers to entry can be structural and strategic barriers.

Structuralbarriersexistsbecauseoftheobjectivefeatureoftheoligopolymarkets. Thisiswhysomeeconomistscalltheinnocentortechnicalbarriers. These are:

• control on specific raw materials in the industry. A typical example is the production of French Champagne from specific grapes grown in Champagne region in France. Other producers cannot grow the same grapes and the incumbent firms enjoy a structural barrier to entry to the industry so that no other competitors can enter. The entry is blocked. Along with such natural production factors, some specific assets, generating a barrier to entry may be the localization of the incumbent firms, the access to the market, etc.

• product differentiation by the incumbent firms, who have created loyal customers. As long as this differentiation has not been created consciously in order to destroy competition, this is a structural barrier to entry.
• Network Effects: If a product becomes more valuable when more people use it, then firms with larger outputs (networks) may have advantages over smaller firms. True, but the source of the advantage is the enhanced value that consumers receive from participating in the network. It's that benefit which keeps consumers in the network and it's that benefit which can limit the entry of new suppliers.
• Economies of Scale: Larger outputs (especially in software) may be cheaper to produce and sell than smaller outputs and low costs certainly can be a barrier to the entry of higher cost firms.
• High capital cost, needed to enter the industry – cost for R&D, advertisement, etc.
• Highswitchingcostforthebuyerstoshifttheirdemandtoothersuppliers.

As a rule, the costs of potential competitors to enter the industry with structural barriers are that high that entry is discouraged.

Strategic barriers, in contrast, are intentionally created or enhanced by incumbent firms in the market, possibly for the purpose of deterring entry. These barriers may arise from behaviour such as:, for example.

• Limitpricing – whentheincumbentfirmsreducethepriceofthegoodsdowntothe levelofnewcomerscostandmaketheindustryunattractive.
• Excesscapacity – incumbentfirms keep excess capacity, which might be used if there is a threat of entry. The load of excess capacity can raise the supply in the industry and reduce the equilibrium price, which would reduce profits and make the industry less attractive for newcomers.
• Threatofupwardordownwardverticalintegration - incumbentfirmscanmergewiththeirsuppliersortheirdistributorsandbuyersand deprive the potential entrants from access to basic supplies or markets.
• “Sleepingpatents” - bigfirmskeeppatentsthat might be introduced when there is a threat of potential competition. If there is not a threat of entry, the patents are kept “sleeping”. Typical examples can be found in pharmaceutical industry.
• Exclusive dealing arrangements ortyingpurchases-theincumbentfirmssetexclusivecontractswiththeirsuppliersorbuyersandrestricttheentryofpotentialcompetitors. TyingpurchasesbecamefamouswiththepracticesofMicrosoft. Theywereevenprosecutedforincludingtheinternetbrowserintheirbasicsoftwarepackage, whichwasdestroyingthebusinessoffirmswhichwereproducingonlybrowsers.

Specific types of barriers to entry are legal barriers. The truly harmful barriers are legal restrictions that prevent firms from entering markets and competing.

For instance, local governments can restrict entry into local wireline phone service, and they can limit competition in cable tv and garbage delivery by licensing selected firms and excluding others.

Other kinds of legal barriers are the permitions to practice a profession (notaries), and patents and copy rights on innovations. The latter however are constructive because without such legal protections on innovations, firms would not invest huge capital in research and technological development.

At the end, let’s mention barriers to international trade like tariffs and quotas that protect national markets fro foreign competition.

d)there are significant barriers to information based on asymmetric information and special efforts of the incumbent firms to deter entry of newcomers.

1. Firm’s conduct

Firm’s conduct is defined as its policies toward its market and toward the moves made by its rivals in that market. It relates to: pricing and product strategies, research and innovations, advertisement and legal practices of the firms.

a)conduct under perfect competition

Perfect competition is a market structure where producers are very small and numerous and supply a homogeneous product. This makes them “price takers” and therefore they cannot set any policies toward their market. The only moves they can make are to respond to market signals in their attempts to maximize profits. They can only determine their level of output so that they maximize profitability.

In other words, we will analyze decisions of perfect competitors how much output they will produce in order to maximize profit.

Profit is maximized when MC = MR and P AC.

Marginal costs dynamics does not depend on the market structure, but on technological factors. We know that in the short run MC are determined by the law of diminishing returns.

We do not know at the moment what are MR of perfect competitors. Now we will find them out.

Under perfect competition the individual firm cannot affect market price of the product. No matter how much the firm produces and sells, it takes the price as given by supply and demand in the market for the product. Thus, if the market price for the product is €5, and a perfectly competitive firm produces 0 units of output, the price will be still €5. The firm is that small that its market share is negligible and if it does not produce, the market supply curve does not shift leftwards. If the firm would produce 10 units of output, this quantity is that small as compared to the market equilibrium quantity, that the supply curve will not shift to the right and the price will stay the same - €5. If it produces 20 units, the market price is still €5. What does this mean for its MR? We will see it on the table below:

Table 1. MR under perfect competition

P / Q / TR / MR = ΔTR : ΔQ
5 / 0 / 0 / -
5 / 10 / 50 / 5
5 / 20 / 100 / 5

If we compare the first and the last column of the table, we will find out that under perfect competitionMR = P.

Since the price of the good does not depend on perfect competitor’s output, its demand curve is presented by a horizontal line. To draw it, we will use the first two columns of the table.

Fig. 2. The firm’s demand curve under perfect competition

Since MR = P, the firm’s MR curve coincides with its demand curve. This curve is perfectly elastic.

Thus, under perfect competition, the demand curve looks differently from the perspective of buyers on the one hand, and from the point of view of sellers, on the other hand. For the buyer, who “draws” it holding in his hands his wallet, the demand curve looks traditionally – it has a negative slope and illustrates the law of demand – the higher the price, the lower the quantity demanded. This is the demand curve for the output of all firms in the industry. In other words, this is the industry demand curve. For the individual seller, the demand curve is perfectly elastic and it is horizontal. These two demand curve are presented on Fig. 3 below. The firm’s demand curve is derived from the industry’s demand curve and it reflects the “price taking” position of perfect competitors.