2 - The Firm and Market Structures

Porter's Five Forces

1. threat of entry 2. power of suppliers 3. power of buyers (customers) 4. threat of substitutes 5. rivalry among existing competitors

Why is it important to understand market structures?

A financial analyst must understand the characteristics of market structures in order to better forecast a firm's future profit stream.

Average Revenue (AR)

AR = TR / Qd The AR function is identical to the market demand function. The assumption is that the relationship between price and quantity demanded is linear

Herfindahl-Hirschman Index

An index where the market shares of the top N companies are first squared and then added

Horizontal Demand Schedule

At a given price, the response in the quantity demanded is infinite. This is the demand schedule faced by a perfectly competitive firm, because it is a price taker (as in the case of a corn farmer). If the farmer tried to charge a higher price than the market, nobody would by the product. The farmer has no incentive to sell at a lower price because she can sell all she can produce at the market price

Average Cost

Average cost (AC) is Total Cost (TC) divided by Output (Q) AC = TC/Q Average cost should be understood to mean average total cost

Competitive Firms

Competitive firms do 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.

Law of Diminishing Returns

Each additional unit of input produces a progressively smaller increase in output

Economic Market Structures

Economic market structures can be grouped into four categories: perfect competition, monopolistic competition, oligopoly and monopoly

Third-Degree Price Discrimination

Happens when customers are segregated by demographic or other traits

Monopolistic Competition

Highly competitive and is considered a form of imperfect competition. Hybrid market - strong elements of competition and also some monopoly-like conditions. The competitive characteristic is a notably large number of firms, while the monopoly aspect is the result of product differentiation. An example is brand loyalty associated with Coca-Cola- customers believe that their beverages are truly different from and better than all other soft drinks. market structure characterized by many sellers with each having some pricing power and product differentiation

Relationship between MR and price elasticity

MR = P[1-(1/εp)]

Opportunity Cost

Measured by determining the resource's next best opportunity

Measuring market power

Measuring market power is complicated. Ideally, econometric estimates of the elasticity of demand and supply should be computed. However, because of the lack of reliable data and the fact that elasticity changes over time (so that past data may not apply to the current situation), regulators and economists often use simpler measures. The concentration ratio is simple, but the HHI, with little more computation required, often produces a better figure for decision making

Oligopoly

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.

Economic Profit

The difference between TR and Total Cost (TC). Economic profit differs from accounting profit because accounting profit does not include opportunity cost. Accounting profit includes only explicit payments to outside providers of resources (e.g. workers, vendors, lenders) and depreciation based on the historic cost of physical capital

Consumer Surplus

The difference between the value that a consumer places on the units purchased and the amount of money that was required to pay for them. It is a measure of the value gained by the buyer from the transaction.

Monopoly

The least competitive market structure. In pure monopoly markets, there are no other good substitutes for the given product or services. There is a single seller, which, if allowed to operate without constraint, exercises considerable power over pricing and output decisions. Example - local electrical power provider (in most cases, the monopoly power provider is allowed to earn a normal return on its investment and prices are set by the regulatory authority to allow that return).

Second-Degree Price Discrimination

The monopolist offers a menu of quantity-based pricing options designed to induce customers to self-select based on how highly they value the product

Oligopoly

The oligopoly market structure is based on a relatively small number of firms supplying the market. The small number of firms in the market means that each firm must consider what retaliatory strategies the other firms will pursue when prices and production levels change. Example - commercial airline companies where pricing strategies and route scheduling are based on the expected reaction of the other carriers in similar markets. A market structure with relatively few sellers of homogeneous or standardized product

Optimal Marginal Revenue

The optimal marginal revenue equals marginal cost. However, only in perfect competition does the marginal revenue equal price. In the remaining structures, price generally exceeds marginal revenue because a firm can sell more units only by reducing the per unit price.

The quantity sold is highest in which market strucutre?

The quantity sold is highest in perfect competition. The price in perfect competition is usually lowest, but this depends on factors such as demand elasticity and increasing returns to scale (which may reduce the producer's marginal cost). Monopolists, oligopolists, and producers in monopolistic competition attempt to differentiate their products so that they can charge higher prices.

Price Elasticity of Demand

The relationship between changes in price and changes in the quantity demanded. Measures the percentage change in the quantity demanded given a percentage change in the price of a given product. Higher price elasticity indicates that consumers are very responsive to changes in price. Lower values for price elasticity imply that consumers are not very responsive to price changes. εp = - (% change in Qd) ÷ (% change in P) Where: εp = price elasticity of demand Qd = quantity demanded P = product's price εp>1 demand is elastic εp = 1 demand is unitary elastic εp<1 demand is inelastic Price elasticity will be higher if there are many close substitutes for the product The greater the share of the consumer's budget spent on the item, the higher the price elasticity of demand Price elasticity of demand also depends on the length of time within which the demand schedule is being considered

Game Theory

The set of tools that decision makers use to consider responses by rival decision makers

Concentration Ratio

The sum of the market shares of the largest N firms Add the sales values of the largest firms and divide this figure by total market sales

Vertical Demand Schedule

The vertical demand schedule implies that some fixed quantity is demanded, regardless of price. An example is insulin (for the diabetic consumer). If the price of insulin goes up, the patient will not consume less of it because the amount desired is set by the patient's medical condition.

Cartel

When collusive agreements are made openly and formally

Substitutes

When the cross-price elasticity of demand between two products is positive Ex: honey and sugar

Complements

When the measure of cross-price elasticity is negative Ex: if the price of DVDs goes up, you would expect consumers to buy fewer DVD players

First-Degree Price Discrimination

Where a monopolist is able to charge each customer the highest price the customer is willing to pay

Economic Profits

While 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.

Stackelberg Model

decision-making strategy in oligopolistic markets (relating to the first-mover advantage) The important difference between the Cournot model and the Stackelberg model is that the Cournot assumes that in a duopoly market, decision making is simultaneous, while Stackelberg assumes that decisions are made sequentially

Cross-price elasticity of demand

the responsiveness of the demand for product A that is associated with the change in price of product B εX = (% change in Qda) ÷ (% change in Pb) εX = cross-price elasticity of demand Qda = quantity demanded of product A Pb = price of product B

Economic Costs

Include all the remuneration needed to keep the productive resource in its current employment or to acquire the resource for productive use

Perfect Competition

Perfect competition is the most competitive environment. An example is a commodities market, where sellers and buyers have a strictly homogeneous product and no single producer is large enough to influence market prices. Profits under perfect competition are driven to the required rate of return paid by the entrepreneur to borrow capital from investors (so-called normal profit or rental cost of capital) 1.) There are a large number of potential buyers and sellers 2.) The products offered by the sellers are virtually identical 3.) There are few or easily surmountable barriers to entry and exit 4.) Sellers have no market-pricing power 5.) Non-price competition is absent Market competitors are least likely to use advertising as a tool of differentiation in this market structure b/c the products cannot be differentiated by advertising or any other means

Marginal Revenue for a Monopoly

Profits are maximized when MR = MC For a monopoly, MR = P [1-(1/1.5)]

Marginal Value Curve

The demand curve can be considered a marginal value curve because it shows the highest price consumers would be willing to pay for each additional unit. The demand curve is the willingness of consumers to pay for each additional unit.

Differences in Market Structures

The categories differ because of the following characteristics: The number of producers is many in perfect and monopolistic competition, few in oligopoly, and one in monopoly. The degree of product differentiation, the pricing power of the producer, the barriers to entry of new producers, and the level of non-price competition (e.g., advertising) are all low in perfect competition, moderate in monopolistic competition, high in oligopoly, and generally highest in monopoly

Marginal Cost (MC)

The change in TC associated with an incremental change in output: MC = ∆TC/∆Q

Marginal Revenue (MR)

The change in total revenue per extra increment sold when the quantity sold changes by a small increment, ∆Qd. MR = ∆TR/∆Qd

Income Elasticity of Demand

The degree to which consumers respond to higher incomes by increasing their demand for goods and services Measures the responsiveness of demand to changes in income εY = (% change in Qd) ÷ (% change in Y) Where: εY = income elasticity of demand Qd = quantity demanded Y = consumer income

Pricing Strategies

There are three basic pricing strategies: pricing interdependence, the Cournot assumption, and the Nash equilibrium Pricing interdependence - price war markets where competitors will match a price reduction and ignore a price increase. By lowering its price to match a competitor's price reduction, the firm will not experience a reduction in customer demand Cournot Assumption: each firm determines its profit-maximizing production level by assuming that the other firms' output will not change. Simplifies pricing strategy b/c there is no need to guess what the other firm will do to retaliate Nash Equilibrium: two or more participants in a non-cooperative game have no incentive to deviate from their respective equilibrium strategies after they have considered and anticipated their opponent's rational choices or strategies. None of the oligopolists can increase its profits by unilaterally changing its pricing strategy

Monopolists

Typically, monopolists sell a smaller quantity at a higher price. Investors may benefit from being shareholders of monopolistic firms that have large margins and substantial positive cash flows