Market Structure and Market
Power
Introduction
• Industries have very different market structures
– By Market Structure, we mean the number of firms in the industry and
how these firms vary in size in term so f market share.
– A industry is HIGHLY CONCENTRATED if most of the production in
the is done by a few, large firms.
• ready-to-eat breakfast cereals: high concentration
• newspapers: low concentration
• StructureConduct Performance (SCP) Paradigm
• By Market Conduct, we mean the manner in which firm set the prices
of the products in the industry
• By Market Performance, we mean the efficiency of the industry and
the profitability / market power of firms in the industry.
• Firms in an industry have Market Power if they posses the ability to
set prices above costs.
Introduction
• The SCP paradigm believed that the market
structure determined market conduct and market
conduct determined market performance.
• Thus, through an examination of the structure of
markets and the organization of firms, the
traditional IO economists thought they could
explain differences in market outcomes.
• By contrast, the New IO begins by investigating
how strategic behavior by firms can affect market
structure.
Chapter 3: Market Structure and
Market Power
3
Introduction
• Despite these differences, the two approaches do
agree that Market Structure - the way that an
industry’s producers are organized - affects what
happens in the market place.
• Moreover, both approaches seek to make causal
inferences about the determinant of Market Power.
• A natural need arises, then, for descriptive
statistics that allow us to characterize Market
Structure and Market Power in a meaningful way.
Chapter 3: Market Structure and
Market Power
4
Introduction
• How best to measure market structure
• A good measure needs to capture the distribution
of firm’s market shares in an industry.
– summary measure.
– concentration curve, which describes the extent to
which output is concentrated in the hands of a just few
firms, is possible (See Figure 3.1).
– preference is for a single number.
– concentration ratio or Herfindahl-Hirschman index.
Chapter 3: Market Structure and
Market Power
5
CRn and HHI
• One way to measure market structure is to focus
on the size of the top firms relative to the industry
• The concentration ratio of n firms is defined as the
sum of market share of top n firms.
• HHI is the sum of squares of market shares of all
firms in the industry.
Chapter 3: Market Structure and
Market Power
6
Measure of concentration
• Compare two different measures of concentration:
Firm Rank
Market
Market Share
(%)
Squared
Share
1
25
625
2
25
625
3
25
625
4
5
25
5
5
25
6
5
25
7
5
25
8
5
25
Concentration Index
CR4 = 80
H = 2,000
Concentration index is affected by, e.g. merger
Firm Rank
Market Share
(%)
1 Assume that firms
2 4 and 5 decide
to merge
3
25
4
5
5
6
7
}
25
625
Market shares
625
change
25
625
5
The Concentration
Index changes
8
Concentration Index
Squared Market
Share
}
10
25
25
5
25
5
25
5
25
CR4 = 80
85
H = 2,000
}
100
2,050
What is a market?
• No clear consensus
– the market for automobiles
• should we include light trucks; pick-ups SUVs?
– the market for soft drinks
• what are the competitors for Coca Cola and Pepsi?
– With whom do McDonalds and Burger King compete?
• Presumably define a market by closeness in
substitutability of the commodities involved
– how close is close?
– how homogeneous do commodities have to be?
• Does wood compete with plastic? Rayon with wool?
Market definition 2
• Definition is important
– without consistency concept of a market is meaningless
– need indication of competitiveness of a market: affected by
definition
– public policy: decisions on mergers can turn on market
definition
• Staples/Office Depot merger rejected on market definition
• Coca Cola expansion turned on market definition
• Standard approach has some consistency
– based upon industrial data
– substitutability in production not consumption (ease of data
collection)
Market definition 3
• Government statistical sources
– FedStats
– Naics
• The measure of concentration varies across countries
• Use of production-based statistics has limitations:
– can put in different industries products that are in the same
market
• The international dimension is important
– Boeing/McDonnell-Douglas merger
– relevant market for automobiles, oil, hairdressing
Market definition 4
• Geography is important
– barrier to entry if the product is expensive to transport
– but customers can move
• what is the relevant market for a beach resort or ski-slope?
• Vertical relations between firms are important
–
–
–
–
most firms make intermediate rather than final goods
firm has to make a series of make-or-buy choices
upstream and downstream production
measures of concentration may assign firms at different stages
to the same industry
• do vertical relations affect underlying structure?
• The existence and variability of vertical relationships can cause
difficulty in measuring the structure of the market at any stage of
production. Example: the bottled, tin and soft drink industry.
Market definition 5
– Firms at different stages may also be assigned to different
industries
• bottlers of soft drinks: low concentration
• suppliers of soft drinks: high concentration
• the bottling sector is probably not competitive.
• In sum: market definition poses real problems
– existing methods represent a reasonable compromise
The Role of Policy
• Government can directly affect market structure
– by limiting entry
• taxi medallions in Boston and New York
• airline regulation
– through the patent system
– by protecting competition e.g. through the RobinsonPatman Act
Measuring Market Power/Performance
• Market structure is often a guide to market
performance
• But this is not a perfect measure
– can have near competitive prices even with “few” firms
• Measure market performance using the Lerner Index
LI =
P-MC
P
Market Performance 2
• Perfect competition: LI = 0 since P = MC
• Monopoly: LI = 1/h – inverse of elasticity of demand
• With more than one but not “many” firms, the
Lerner Index is more complicated: need to average.
– suppose the goods are homogeneous so all firms sell at the
same price
LI =
P-SsiMCi
P
Lerner Index: Limitations
• LI has limitations
– measurement: as with “measuring” a market
– meaning: measures outcome but not necessarily
performance
– misspecification:
• if there are sunk entry costs that need to be covered by
positive price-cost margin
• low price by a high-cost incumbent to protect its market
Empirical Application: How Bad is Market
Power Really?
• Harberger (1954) exercise: Welfare Loss (WL) is:
1
WL = 2 (P – MC)(QC – Q)
• Welfare Loss in relation to sales:
WL = 1 (P – MC) (QC – Q)
Q
P
2
PQ
• This can be expressed as:
WL = 1
PQ
2
η (LI)2
How Bad is Market Power Really? 2
• Because most industries are not perfect monopolies,
Harberger (1954) calculates
WL = 1 η (LI)2
PQ
2
• For 73 manufacturing industries assuming D=1.
Multiplying the result by each industry’s output
and summing over all industries he estimates a
total welfare loss from monopoly power of
about one-tenth of one percent of GDP.
How Bad is Market Power Really? 3
• Currently, the budget of the Justice Department
and the FTC is between one and two-tenths of 1
percent of GDP. While much of this is for
activities other than antitrust enforcement, the low
value of Harberger’s (1954) estimate still raised a
serious question about the cost-effectiveness of
antitrust policy.
Chapter 3: Market Structure and
Market Power
20
How Bad is Market Power Really? 4
• One problem is cost, possibly due to how advertising is
2
treated
(P
–
MC)
WL = 1
2 η
PQ
P
• Under imperfect competition, MC may not be
minimized, so P – MC may be artificially low.
• Corrections by Cowling and Mueller (1978) and
Aiginger and Pfaffermayr (1997) raise total cost
substantially to between 4 and 13 percent of GDP
How Bad is Market Power Really? 4
•
1.
2.
Two caveats (at least):
An implicit assumption in all these calculations is that it
is feasible to have perfect competition in all industries.
But costs and technology make this an unlikely outcome.
In this sense, the estimates of welfare losses due to
monopoly price distortions are too high.
The measures are taken from data in which active
antitrust enforcement has been the form. In this sense, the
measures are an understatement of the potential
monopoly-induced welfare losses.
Chapter 3: Market Structure and
Market Power
22
Fast-Food Outlets
McDonald’s
Burger King
Wendy’s