Determinants of Market Structure

Topics for Discussion

The Debate

Economies of Scale
Product Differentiation Absolute cost advantages

The Debate
Market structure and its implications to conduct and

performance especially to control prices has been explored Market structure itself is a result of economic forces S-C-P framework holds that market structure is dependent on the underlying technology and strategic behaviour of firms Chicago economists criticize this
The essence of monopoly is the ability to prevent

expansion on capacity when price exceeds unit cost No theoretical link has been forged between the structure of industry and the degree to which competitive pricing prevails Market structure reflects something more than efficiency (role of govt to keep the rivals from entering)

Determinants of Market structure

Bain identified three elements of market structure

as the main determinants of the nature of entry conditions

Economies of scale Product differentiation

Absolute cost advantages of existing firms

Economies of Scale
Economies of scale and proportion of fixed cost in

total cost Short run equilibrium Long run Number of firms

Market performance
Changes in market performance and relation with

fixed cost and economies of scale Lower fixed cost, greater the number of firms in LR equilibrium; closer the Eq. Price to MC and less the degree of market power exercised by individual firms Trade off between FC and market performanceRole of MES; Thus, market concentration is expected to increase with economies of scale but the market performance is expected to worsen off
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Policy implications
In LR, Market concentration would approach the

level dictated by cost function; so there is little policy makers can do about it Strategic entry deterring behaviour of large firms to maintain market share would make them operate at scales that are inefficient (SCP) Estimates of efficiency and MES flawed; the market structure observed in real world is efficient (Chicago) When market economy is at work, size of firms should not be a matter of concern
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Product Differentiation
Methods of differentiating
Advertising Efforts of sales forces Design changes After sales etc

Advertising
Advertising affects demand curve

Advertising in turn affects profit as well as profit

maximizing output Advertising influences price elasticity of demand Advertising sales ratio is determined by two factors
Price-cost margin: firms advertise more, the more

they make on the sale of the marginal unit Elasticity of demand with respect to advertising: firms advertise more, the more sensitive is the quantity demanded to advertsing
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Advertising and absolute cost advantages

Time lags
If past advertising does not affect current demand,

then ads are not a barrier to entry for new firms However, in reality, brand image is created by incumbent firms and it creates an absolute cost advantage Rate at which the effect of advertising on demand depreciates varies from industry to industry
Cumulative affect of ad on sales of mature, frequently

purchased, low-priced products occurs within 3-9 months of ad

Ad effect/brand loyalty modest or enduring as

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entry barrier thus varies

 Noise:
Ad of incumbent firm interferes with that of new

firms When there is noise in the market, one must shout louder to be heard.puts the new firms at cost disadvantage as compared to existing firms
Market Penetration cost-entry barrier; market

power for existing firms

Avg. cost of production as well as of distribution will

be higher for new firms Figure 8.3

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Product differentiation and Economies of Scale

Minimum amount of ad expense is needed before it starts

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making impact on public This is FC of ad Threshhold effect- it is the size of audience that must be reached that determines the expenditure, not the firms sales (national market) Ad exp of exiting firm and new entrant would be same; entrants output small as compared to existing firm, making the unit cost of ad higher for the former Regional markets Repetition effect-effectiveness of advertisement (experience effect) Rate structures of advertising media (spot ad vs. network ad) This limit price differential is independent of the gap created by market penetration cost

Product differentiation and welfare

Figure 8.4

Monopolists advertise too much, from social point

of view because they take decisions based on their private MR and MC; they do not consider the additional cost incurred on consumer in the form of higher prices Oligopoly results in even more excessive advertising; if they succeed in controlling price competition, then they divert their rivalry in marketing efforts
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Capital requirements
Why firms might have a cost advantage over

potential entrants at all levels of output independent of scale differences and advertising Patents, control of inputs will be important in some industries more than others Working of financial capital market is cited as a general source of absolute cost advantage of established firms
Higher effective interest cost (cost of capital) Severe rationing of funds on potential entrants

Inefficient capital market/uncertainty/ asymmetrical information/reputation/

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Empirical findings
MES (Martin)

Advertising : media impact/ (Mueller and Rogers)

Kessides: sunk cost/odds of successful entry

increase as ad per unit of sales grows Results vary in different segments/industry to industry

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