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. Chapter 4 introduce the firm and market structures. Inviting you refer.
Chapter The Firm and Market Structures Presenter’s name Presenter’s title dd Month yyyy Introduction 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 Copyright © 2014 CFA 2 Analysis of market structures Copyright © 2014 CFA Determinants of market structures Copyright © 2014 CFA Characteristics of Market Structure Barriers to Entry Pricing Power of Firm Nonprice Competition Homogeneous/ Standardized Very Low None None 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 Market Structure Number of Sellers Perfect competition Many Monopolistic competition Copyright © 2014 CFA Degree of Product Differentiation 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 Copyright © 2014 CFA 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 Price elasticity depends on whether the price is increased (relatively MR inelastic) or decreased (relatively elastic) MC3 P MC2 Kinked demand curve MC1 MR Q Copyright © 2014 CFA Quantity 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 Copyright © 2014 CFA Supply functions Copyright © 2014 CFA Profit-maximizing price and output Copyright © 2014 CFA 10 Factors affecting long-run equilibrium Copyright © 2014 CFA 11 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) Copyright © 2014 CFA - 12 Concentration measures The concentration ratio is the ratio of The Herfindahl–Hirschman Index the sales of the 10 largest firms in the (HHI) is the sum of the squared market industry divided by the total sales of the shares of the top N companies industry - The higher the HHI, the more - Ranges from (perfect concentrated competition) to 100 (monopoly) - Advantages - Advantages Easy to compute Easy to compute Affected by mergers of the larger - Disadvantages competitors - - Does not quantify market power Does not consider the ease of entry into the market Unaffected by mergers of the larger competitors Copyright © 2014 CFA - - Disadvantages - - Does not quantify market power Does not consider the ease of entry into the market 13 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 Copyright © structures, 2014 CFA price generally exceeds marginal revenue because a14firm remaining • 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 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 â 2014 CFA 15 - 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 16 ... marginal revenue is positive, demand is elastic Copyright © 20 14 CFA Supply functions Copyright © 20 14 CFA Profit-maximizing price and output Copyright © 20 14 CFA 10 Factors affecting long-run... 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... marginal revenue equal price In the Copyright © structures, 20 14 CFA price generally exceeds marginal revenue because a14firm remaining • Conclusions and Summary • • • The quantity and price in