STRUCTURE, CONDUCT AND PERFORMANCE
SECTION 1. WHAT IS THE MARKET AND HOW IS IT MEASURED? 10
EXAMPLE: THE MARKET FOR COPIERS 11
SECTION 2. BASIC CONDITIONS OF A MARKET 12
conglomeration 12
vertical integration 12
marginal cost pricing 13
market power 13
efficient allocation of resources 13
product differentiation 14
C. Market Supply Conditions 14
1. Long Run: Investment Decisions 14
technical efficiency 14
efficient investment 15
2. Short Run: Production Decisions 15
efficient utilization 15
D. Efficiency and Interaction of Supply and Demand 15
EXAMPLE: BASIC SUPPLY AND DEMAND CONDITIONS FOR COPIERS 15
SECTION 3 MONOPOLY 18
A. Structure of Monopoly 18
barriers-to-entry 18
patents 18
information asymmetry 19
B. Monopoly Conduct 19
C. Performance of Monopoly 20
X-inefficiency 20
EXAMPLE: XEROX AS A MONOPOLIST 21
Figure 10-3. Locating Profit Maximizing Output 22
SECTION 4. OLIGOPOLY 25
interdependent 26
competitive rivalry, 26
A. Structure of Oligopoly 26
B. Conduct of Oligopoly 26
horizontal merger 27
vertical merger 27
Backward vertical integration 27
forward vertical integration 27
conglomerates 27
cross-subsidize 27
Mutual forbearance 27
1
Market extension 27
Product extension 27
Pure conglomerate 27
price war 27
predatory pricing 28
Tacit collusion 28
Price leadership 28
non-price competition 28
C. Performance of Oligopoly 28
contestable 29
EXAMPLE: XEROX AS AN OLIGOPOLIST 29
A. Pricing Policy 29
Figure 10-4 Alternative Optimization Strategies 29
law of one price 30
B. Non-Price Strategies Driven by Interdependence 30
SECTION 5. MONOPOLISTIC COMPETITION 32
A. Structure of Monopolistic Competition 32
monopolistic competition 33
B. Conduct in Monopolistic Competition 33
C. Performance in Monopolistic Competition 33
EXAMPLE: XEROX IN MONOPOLISTICALLY COMPETITIVE 34
Figure 10-5 Monopolistic Competition Error! Bookmark not defined.
SECTION 6. COMPETITION. 36
A. Structure of Competition 36
B. Conduct in Competition 37
competitive equilibrium 38
C. Performance in Competition 38
EXAMPLE: A COMPETITIVE COPIER MARKET 39
Figure 10-7. Entry and Exit in Competition 40
SECTION 7. SUMMARY 41
BIBLIOGRAPHY 42
DEFINITIONS 43
The Xerox Corporation, the innovator that brought the copy machine to market in 1959,
found itself by the turn of the 21st century in serious financial problems. In 2000 it announced
that its Mexican subsidiary had committed fraud, and major officers of the firm were replaced by
the board. In 2001 KPMG, the accountant for Xerox, forced Xerox to reduce its shareholder
equity, and Xerox replaced them with Price-WaterhouseCoopers. However, by April of 2002,
the Securities and Exchange Commission (SEC) planned to file charges against Xerox for
misstated financial reporting, and Xerox offered to restate its financial results back to 1997 and
to pay $10 million to settle the dispute- an amount larger than any previous fine for misreporting
The seeds to such financial debacles are often laid in the competitiveness of a market. Xerox
effectively started as a monopolist--the only producer of a plain-paper copier. It lost its
monopoly when Kodak, IBM, and Japanese firms entered the market. With a few,
interdependent firms, the copier market became an oligopoly. But in the lower segments of the
2
copier market, so many firms entered that Xerox found itself fighting to survive as if it were in a
competitive market. By 2000, Canon and Ricoh had gained significant market share in the
market for superfast copiers which were the high-end, high-margin life blood of Xerox’s product
line. By following the Xerox experience, this chapter will show the differences between
monopoly, oligopoly, and competitive markets and how a firm must adapt to changing market
structure in order to survive.
SECTION 1. PROFIT MAXIMIZATION
If a firm is to achieve its maximum profit goal, its managers cannot be simply revenue
maximizers or cost minimizers. They must maximize profit, the difference between revenues
and costs. Not only is it difficult to match revenues to costs from an accounting standpoint, it is
also difficult to make the economic decision of the price and output levels that will maximize
profit.
A. Rules of Thumb Used by Business that Fail to Maximize Profit
While it has been long assumed that firms are profit maximizers, the last fifty years has
provided significant evidence that firms use a wide variety of different rules-of-thumb, many of
which seriously fail to lead to maximum profit.
In an early attempt to find the basis for company pricing, the Brookings Institution
undertook a survey of the largest U.S. corporations. In a report1 on the survey2 Robert F.
Lanzillotti identified several pricing objectives of firms including (1) pricing to receive a target
return on investment, (2) stabilization of price margins, (3) pricing to obtain a given market share,
and (4) pricing to meet or prevent market competition. Both pricing to maintain a "target return on
investment" or a "margin" involve a full-cost pricing.
Full-cost pricing means that a price is determined on the basis of both variable (V) and
fixed (F) explicit costs- which can generally be provided by a firm's accountants. To allocate
explicit costs, a standard volume, Q*, is determined which is the firm's targeted or expected
production level. The standard unit cost (UC) is then given by the formula:
(1)
UC = V + F = UV + UF
Q* Q*
where UV and UF are the unit variable and unit fixed costs respectively. For example, if a firm
expects to produce a standard volume of 10 units of output where unit variable costs are $5 and
explicit fixed costs are $30.00, then the standardized unit cost would be $8 (=$5+(30/10)). Since
1 Robert F. Lanzillotti "Pricing Objective in Large Companies" American Economic Review 58 (December 1958,
pp. 921-940).
2 A. Kaplan, J. Dirlam, and R. Lanzillotti. Pricing in Big Business. (Brookings Institution, Washington, D.C.
1958)
3
the formula (1) includes only explicit costs, the unit costs are equal to or smaller than true economic
costs.
Managers have a variety of ways of defining some margin or “fudge factor” above costs that
include the missing, implicit costs as well as some notion of a "satisfactory profit." There are many
approaches which could be used, but perhaps the most popular approach is the margin
maintenance. The satisfactory unit profit can be stated in terms of a desired margin above costs.
The profit margin (*) desired by the company is commonly expressed as a percentage above
standardized unit costs. The margin maintenance method of setting price, P, is:
(2) P = (UV+UF)*(1+*)
If a company wants a 50% margin over a standardized unit cost (UV+UF) of $8, then the price
would be $12.00 (=$8*(1+50%)). These full cost pricing methods are often quite elaborate, but
they all boil down to a procedure of estimating unit costs and adding a desired amount to cover
profit and any implicit costs.
But such cost based formulas are not consistent with profit maximization and may actually
endanger firms during recessions or off-peak business periods, particularly when output is anything but
predictable or “standardized.” In fact, full-cost pricing often encourages firms to raise prices in the face
of recessions in order to maintain their margins. And what will that do to their business? They’ll be
laying off employees and forcing business to contract even more than they would have if they had left
prices unchanged.
Nevertheless, many studies that followed the initial study by the Brookings Institution found
many inappropriate pricing techniques being used by business. Small businesses which often live on a
precipice are prone to make some of the biggest and most dangerous mistakes in the way that they price
their services. Retail businesses such as pharmacies may try to maximize the profit margins they make
from the drugs they disperse, but instead of maximizing profit such companies will find that they lose
customers to their competitors because the high margin items have low customer bases. Manufacturing
businesses may try to maximize revenue, but soon they will find that they are making sales where price
doesn’t cover the costs to service the customers. To avoid such problems some companies may offer
service until average costs begin to exceed average revenue, which is called average cost pricing.
Unfortunately, that strategy leads to zero profitability.
B. The Correct Rule of Thumb: Marginal Revenue = Marginal Cost
Why don’t firms just use the correct rule to maximize profit? In other words, why don’t
they just project the revenues and costs that result at different price and quantity combinations?
The “projecting” is difficult. Few businesses know how to forecast very well, many of them
don’t do any forecasting, and that means they don’t know what revenues and costs are until long
after (at least a quarter) they have to make pricing decisions. Most of them need rules-of-thumb
that can be easily used by any employee entrusted with pricing decisions. The easier the rule-ofthumb, the more employees can be entrusted with decentralized price making decisions.
4
Unfortunately, the easiest CORRECT rule-of-thumb is not that easy. It involves marginal
revenue and marginal cost. In other words, it involves the revenues and costs from doing the
next unit of business. Managers generally have an on-going sense of how much extra cost or
revenue will be experienced with each sale that is made. It is that intuitive sense which
economists wish to encourage managers to follow in their profit making decisions. If the
employees can be given the concept of marginal revenue and marginal cost, without too much of
the sophisticated definitions and economic modeling that goes along with it, they may be able to
apply the concepts… and may be doing so without formal knowledge of them.
Of course, you get the sophisticated economic modeling and definitions to see why the
correct rule of thumb works. That means you need to get reacquainted with marginal revenue
and marginal cost. Marginal revenue is the addition to total revenue from selling an additional
unit. It can always be approximated by dividing the change in total revenue (also referred to as
"incremental revenue") by the change in quantity demanded
MR = TR2-TR1
Q2-Q1
where the total revenue from two different choices, TR1 and TR2, can be matched to their
associated quantities, Q1 and Q2. Similarly marginal cost is the addition to total cost from
selling an additional unit of output. It can always be approximated by dividing the change in
total cost (also referred to as "incremental cost") by the change in quantity supplied:
MC = TC2-TC1
Q2-Q1
where the total cost from two different choices, TC1 and TC2, can be matched to their associated
quantities, Q1 and Q2.
The fundamental rule for maximizing profit in any type of market can be stated as follows:
PROFIT MAXIMIZING RULE (FIRST ORDER CONDITION): Profit is maximized at
the output level where marginal revenue equals marginal cost.
If marginal revenue is greater than marginal cost the firm can increase profit by expanding
output; if marginal cost is greater than marginal revenue, the firm can increase profit by reducing
output. Simply be computing whether the revenue is greater than the cost from the next sale (not
all previous sales), an employee gets the right signal about whether or not to make the sale. By
following that rule, profit is maximized for the whole firm.
However, the marginal revenue-equals-marginal cost rule is only the first order condition
for profit maximization, and it also is satisfied when profits are minimized! A second order
condition is required to distinguish a profit minimum from a profit maximum:
PROFIT MAXIMIZING RULE (SECOND ORDER CONDITION): When the first
order condition is satisfied and if the rate of change in marginal cost is greater than the
rate of change in marginal revenue, then profit will be at a maximum. If the rate of
5
change in marginal cost is less, then profit will be at a minimum.
Why worry about marginal cost and marginal revenues? Why be so technical? Because it’s better
know the right way to maximize profit than to use some rule of thumb that will actually result in
much lower profits.
C. Summary
What might seem logical in a pricing strategy can be very misleading unless the implications are
understood. Nevertheless, before we are too quick to dismiss how businesses do their pricing, we may
find that industry pricing practices appear to sacrifice profitability because underlying supply and
demand conditions prevent such profits from being earned. In the next two sections, the nature of
supply and demand are shown to be crucial to the way in which prices, output, profitability, and
efficiency can be achieved for different kinds of markets.
EXAMPLE: USING EXCEL TO DETERMINE PROFIT MAXIMIZATION CORRECTLY
Suppose the Xerox company had forecasted 12 different scenarios at which it could produce and
sell copiers, as shown in Figure 4-1. Column A shows the different outputs that they could produce
in thousands of copiers per month. The revenues and costs that Xerox might project in each of the
scenarios is shown in millions of dollars per month in the columns B and C respectively. Total Profit
for each scenario can be found quite easily with EXCEL by placing the formula (=B2-C2) in the
column D2 and dragging it down (place cursor on corner of cell and then hold mouse down as pull
the cursor through the column). The maximum profit occurs at 5,000 copiers per month. Xerox
should produce 5,000 copiers per month to maximize profitability.
Figure 4-1. EXCEL Spreadsheet of Scenarios For Xerox
A
1
2
3
4
5
6
7
8
9
10
11
12
B
Total Rev
($mil/mo.)
Output
(000s/mo.)
0
2.5
5
7.5
10
12.5
15
17.5
20
22.5
25
C
Total Cost
($mil/mo.)
0
55
70
82
92
100
108
122
140
157
175
D
Total Profit
($mil/mo.)
0
22
37
50.25
61
70
79.5
105
140
186.75
250
E
Av Profit
($000/unit)
0
33
33
31.75
31
30
28.5
17
0
-29.75
-75
11.0
8.3
6.4
5.2
4.3
3.6
1.9
0.0
-2.7
-6.3
From this raw data, we can see what different rules of thumb might suggest for output and price
decisions that Xerox should make. One popular rule of thumb that firms use, particularly at the
wholesale and retail levels, is based on average profitability. Average profit is found by dividing
profit by output to find how much profit there is per unit of output. In EXCEL this can be found by
placing the formula (=D3/A3) into third row of column E (Note: don’t start in 2nd row because you
would have to divide by zero). Notice that average profit does not peak at the same output as profit
6
does. When firms determine how much to produce and price by using maximum average profit, they
invariably will produce less than they should to achieve maximum profit. Such under production
tends to keep their prices too high and make them vulnerable to firms who might enter their market.
There are many other rules of thumb used by businesses. To compute these rules of thumb it is
useful to compute the average and marginal data that correspond to the revenue and cost data (Figure
4-2).
Figure 4-2. Averages and Marginals in EXCEL
A
B
C
D
E
F
G
H
1 Q
TR
AR($000/un MR
TC($mil/m AC
MC
Full
(000s/m
($mil/mo it)
($000/un o.)
($000/un ($000/un Cost
o.)
.)
it)
it)
it)
P
2
0
0
0
3
2.5
54
21.6
21.6
22
8.8
8.8
13.2
4
5
70
14.0
6.4
37
7.4
6.0
11.1
5
7.5
82
10.9
4.8
50.25
6.7
5.3 10.05
6
10
92
9.2
4.0
61
6.1
4.3
9.15
7
12.5
100
8.0
3.2
70
5.6
3.6
8.4
8
15
108
7.2
3.2
79.5
5.3
3.8
7.95
9
17.5
122
7.0
5.6
105
6.0
10.2
9
1
20
140
7.0
7.2
140
7.0
14.0
10.5
0
1
22.5
157
7.0
6.8
186.75
8.3
18.7 12.45
1
1
25
175
7.0
7.2
250
10.0
25.3
15
2
NOTE: TR= total revenue, AR= average revenue, MR=Marginal Revenue, P=Price
TC= total cost, AC= average cost, MC=Marginal Cost
EXCEL makes it easy to compute the averages and marginals associated with revenues and costs.
Use the Insert Column command to get the new columns inserted into the spreadsheet that was
shown in Figure 4-1. Then in the third row (remember, you can’t divide by zero) of each column you
place the following formulas and just drag them down the column:
Column C: =B3/A3 Average Revenue (which is the same as price) is just Total Revenue (B3)
divided by output, Q, (A3).
Column D: =(B3-B2)/(A3-A2) Marginal Revenue is the change in Total Revenue (B3-B2) divided
by the change in output, Q, (A3-A2)
Column F: =F3/A3 Average Cost is just Total Cost(F3) divided by output, Q, (A3).
Column G: =(F3-F2)/(A3-A2) Marginal Cost is the change in Total Cost (F3-F2) divided by the
change in output, Q, (A3-A2)
Column H: =F3*(1+.20) For our full cost pricing model, we’ll assume that standardized unit cost is
just average cost (column F) and we’ve put a 50% margin above that cost.
7
After computing this information, EXCEL let’s us graph the information. Since the units of
measurement are the same for marginal and average data (for both revenues and costs), EXCEL
allows us to graph all of the marginal and average curves together as shown in Figure 4-3. Such a
graph is very helpful in the analysis of rules-of-thumb, particularly the rules based upon where two
items are equal to each other. Each of the following plausible rules-of-thumb used by businesses
gives different answers about what the appropriate scenario to choose in the Xerox Case:
Minimum Total Cost: Zero Output
This goal almost always leads a firm to produce nothing where, of course, total costs are zero.
This wouldn’t be so important except that Purchasing and Human Resource managers can
sometimes find their pay policies set up so that they have an incentive to minimize all costs
which would be sub optimal for the company.
Maximum Total Revenue: 25,000 copiers per month
This goal always leads a firm to produce too much. In our example the firm maximizes total
revenue at 25,000 copiers, but also achieves negative profitability because costs have risen so
high. Marketing departments particularly tend to be rewarded on the basis of sales, which can
lead them to sell more than is profitable for the company.
Minimum unit cost (minimum average cost): 15,000 copiers per month
By ignoring revenues and demand, a firm ignores where the money for a firm is coming from.
If demand is adequate, this rule will lead to production levels below what is most profitable.
But if demand is inadequate, the firm may be struggling for minimum average costs, but
won’t be able to sell everything that is produced. Production managers who are too optimistic
about how much they can sell can easily fall into this mistake.
Minimum Marginal Cost: 12,500 copiers per month
This rule is a more sophisticated imitation of the minimum unit cost rule and suffers from the
same problem of ignoring demand and revenues. Purchasing managers who are continually
scurrying for the best deal may trap a firm into this rule if they refuse to buy enough
inventory at higher prices to meet a company’s profit maximizing goal.
Maximum Price (maximum average revenue): 2,500 copiers per month
By the law of demand the maximum price can be achieved by producing just one unit of
output. That usually means too little is produced. Top-of-the-line businesses such as some
apparel designers may be forced to produce unique items because of the nature of their
market, but very quickly mass producers will follow with cheaper imitations that can take the
profitability out of a market very quickly. Those Botox parties are going to become a lot less
expensive very soon.
Average Cost Pricing (Price = average cost): 20,000 copiers per month (i.e. Zero profits)
Notice that zero profit is made when enough output is produced that price equals average
costs. While clearly counterproductive, this kind of pricing is typical of regulated industries
because that is the kind of pricing rule that is easy for regulators to compute and to hold
companies to. The most famous example of this was the regulation by the Interstate
Commerce Commission of the railroads; by not allowing railroads to abandon track that was
profitable, the Penn Central railroad held onto so much track that it finally went bankrupt.
Marginal Cost Pricing (Price = marginal cost): Between 15,000 and 17,500 copiers per month.
Economists find that many firms effectively produce up to the output level where marginal
costs equal price. This only maximizes profitability if the firm cannot affect prices (the
demand curve is flat), and that only happens in perfectly competitive markets or markets with
8
a price control.
Full Cost Pricing (Full cost Price= Price): Between 10,000 and 12,500 copiers per month.
This rule is easily manipulated. By picking a large enough margin, it is possible to choose
almost any level of output as optimal. However, if demand shifts the rule can lead the firm to
undesirable adjustments of output and price.
Marginal Revenue=Marginal Cost as MC rises above MR: Between 5,000 and 7,500 copiers per
month.
This is the rule that is always correct. But we have to look carefully to find the output
where it is satisfied. We have to look for the output which marks the point at which
marginal cost first becomes higher than marginal revenue. At or immediately before that
output level, profit is maximized. Figure 4-3 helps us find this point very easily.
Almost every scenario is the choice of at least one rule of thumb. If someone in a firm wants a
particular scenario they may be able to find a rule-of-thumb that justifies it. Policies and
incentives must be instituted to ensure the correct rule is used. An incautious manager who does
not realize how misleading these different rules are, can inadvertently close down an otherwise
profitable business by running the business according to the wrong rule.
Figure 4-3 Average and Marginal Curves
Price ($thousands/unit of output)
30
25
20
15
MC
MR
Demand (price)
10
AC
<--MR=MC
5
0
9
SECTION 2. BASIC CONDITIONS OF A MARKET THAT CONTROL PRICING AND
OUTPUT DECISIONS
Before we are too quick to dismiss how businesses do their pricing, we may find that
industry pricing practices appear to sacrifice profitability because underlying supply and demand
conditions prevent such profits from being earned. In the rest of this section, the nature of markets
and supply and demand are shown to be crucial to the way in which prices, output, profitability, and
efficiency can be achieved. These basic conditions of a market are crucial to a meaningful
competitive analysis of that market.
A. What Is The Market And How Is It Measured?
A market is, intuitively, a place where goods, services, or other items of value are
exchanged, generally for money. However, a definition of a market can be no stronger than the
marketer's ability to recognize, conceptualize, and stay continually in touch with the potential
buyers' needs and ability to pay. During the eighties, Mike Milken created a gigantic market for
junk bonds with a concept- that low grade debt was not as risky as its ratings and prices
suggested. When Mike Milken was indicted for illegal transactions, the junk bond market, and
his firm- Drexel Burnham- crashed. The basis for defining a market can be very intangible and
quite temporary.
To get a hold on the concept of a market and to use the concept strategically, it must be
defined. To define a market clearly, market boundaries must separate those items which
substitute for each other from those which do not. In antitrust law, where battles over market
extent are crucial to the resolution of many cases, products can be considered in the same market
only if they are interchangeable, are of substantially the same quality, and have similar end uses.
Economists use a variety of tools to test for these standards:
(1) Cross Price Effects. Suppose two different goods appear to be in the same market. A
change in the price of one good should affect the quantity demanded of the other one. If
the cross price elasticity is positive (the percentage increase in the price of one leads to
some percentage increase in the quantity demanded of the other) then the two goods may
be substitutes, and the market boundaries may be defined to encompass both goods. If
not, then a market boundary may classify the two goods into different markets.
(2)
(2)
Similar Price Behavior. Prices of different goods often move together even though they
are not within the same market. While similar movements in prices do not prove that two
goods are within the same market, the absence of similar price behavior is good evidence
that the two goods are in different markets.
By a series of such tests of the extent of the market, it should be possible to classify which goods
substitute for each other at different locations, in different quantities, in different varieties, and
for different purposes.
Common business practice is a very useful source for insights about strategically useful
boundaries. Many different criteria are commonly used for defining market boundaries; price
10
Chapter 4
11
differences among products, quality differences among products, geographic factors, costs of
transporting a product, the feasibility of transporting the product, political boundaries such as
state or county lines, the size of purchase, credentials of the buyers, other characteristics of the
buyers, the terms of purchase (such as leasing versus selling), the timing of purchases, the
manner of promotion, and the habits of buyers or sellers. Even this list does not exhaust the
useful list of classification schemes- as varied as the creativity and experience of the
entrepreneurs who conceive of goods for the needs and pocket books of their clients.
EXAMPLE: THE MARKET FOR COPIERS
Generally the best place to find what the markets are, how they are defined and their
boundaries is through private sources of information, particularly when you are doing a business
plan. Such sources show your familiarity with the market that you are entering. Many industries
and trade associations classify markets according to their customary business practices that
develop through time. A market can often be described and classified based on information
available in the books, media or the press.
But the market boundaries are constantly changing. In the case of Xerox, the market
boundaries have been continually changing over its history. For example, a book by Gary
Jacobson and John Hillkirk called XEROX: AMERICAN SAMURAI (Macmillan: New York
1986) provides a quite useful view of the copier market that existed in the 1980s. They describe
the boundaries of the copier market as follows:
People tend to view the plain paper copier market as one huge continuum. It isn't. It is
many smaller segments, each with a different set of customers and a different set of
competitors. ... There are customers who expect the supplier to do all the servicing, and
fast. And there are customers who want to take care of the machines themselves. Some
major accounts take hundreds of machines while some small offices take only one. There
are machines with fancy input and output devices that allow the customer to make and
bind booklets. And machines that don't do much except make a lot of copies in a hurry.
Xerox has to satisfy everyone from dedicated operators in company copy centers to
casual operators who walk up to a machine in a hallway.i
Each of these characteristics is defined in terms of the buyers' needs and can serve as a basis for
distinguishing different products within the overall copier product line. Hillkirk and Jacobson
continue:
There is some overlap in the market segments, and the boundaries are always changing...
Dataquest, probably the foremost research firm covering the field, used to divide the
PPC(plain paper copier) industry into six segments.ii
The Dataquest segments appear in Table 4-2. Hillkirk and Jacobson indicate how fluid market
boundaries are when they note; "The research firm [Dataquest] ... has recently redefined its own
system..."iii They also note that Xerox has its own classification.
11
Chapter 4
12
Each of us could probably guess why Table 4-2 no longer represents the copier market. If we
were to look at the copier market today, the costs of the categories are significantly lower,
copiers serve multiple functions (eg. as printers and fax machines), the quality of the copies is
significantly better, and the speed of the machines is much faster (91 copies per minute would be
considered slow). These changes force market boundaries to change. Market definitions are
different for different users at different times for different purposes. Defining the market
properly in a business plan becomes a significant task and one that indicates how much you
really know about the market you are trying to enter.
Table 4-2. Definitions of Copier Product
===========================================================
Dataquest
Xerox
Category Copies/Minute
Maximum Cost Category
___________________________________________________________
PC
1-12
$1,000
Low-volume
1A
1-15
$2,000
Low-volume
1B
15-20
$4,500
Mid-volume
2
21-30
$5,000
Mid-volume
3
31-45
$7,500
Mid-volume
4
40-75
$20,000
Mid-volume
5
70-90
$60,000
Mid-volume
6
91 plus
$130,000 High-volume
===========================================================
B. Demand Conditions in a Market
Economists classify markets according to certain key characteristics which are grouped
into three categories:
1)
2)
3)
STRUCTURE. The structure of a market can be described by the number of sellers, the
number of buyers, the loyalty of customers, the degree to which businesses have
diversified into non-related markets (conglomeration), and the degree to which
businesses have expanded into their customers' or suppliers' businesses (vertical
integration).
CONDUCT. Conduct refers to the policies of the firms within a market regarding
pricing, product quality, production, advertising, research, innovation, investment,
strategies to deter entry, exit, legal activity, and other managerial actions.
PERFORMANCE. Performance indicates the results of a firm's conduct with respect to
efficiency in the allocation of resources, profitability, pricing, and the adoption of new
techniques and products. Performance can be viewed in the context of social goals such
as equity and full employment.
12
Most markets can be classified on the basis of these characteristics and, as we examine the
evolution of the copier market we will see that the characteristics of a market can change. The
reason they change can be found in the underlying supply and demand conditions.
The slope of the demand curve from the viewpoint of a firm determines how a firm will
try to maximize its profitability. When a firm produces an output at which price equals marginal
cost it is said to be using marginal cost pricing. The slope of the firm's demand curve
determines if it maximizes profit through marginal cost pricing. From the rules above, if a firm
is to maximize profit it must focus on marginal revenue. Marginal revenue equals price only if
the firm's demand curve is flat; in that case alone, the production of greater output does not result
in lower revenue as price falls. A flat demand curve means the firm is a price taker because it
cannot influence the market price by changing its output. By producing the quantity where
marginal cost equals marginal revenue, a firm facing a flat demand curve simultaneously applies
marginal cost pricing and contributes to an efficient allocation of society's scarce resources in the
long run.
However, if the demand curve is not flat, the firm has market power, which is the ability
to influence price by altering its output. When a firm's demand curve is downward sloping the
marginal revenue curve falls below the demand curve, and price exceeds marginal revenue at
every output. Since profit maximization occurs where marginal revenue and marginal cost are
equal, price also must be greater than marginal cost. A firm facing a downward sloping demand
curve fails to allocate society's resources efficiently because the profit maximizing price exceeds
marginal cost. It does not use marginal cost pricing.
The slope of the demand curve will also determine if a firm efficiently utilizes society's
scarce resources. An efficient allocation of resources is achieved when the price charged by the
firm is equal to the marginal cost of producing a good. If a firm charges a price above marginal
cost, some potential buyers who would be willing to pay prices that would cover marginal cost
simply have to go without the good, or are forced to purchase something else which is less
satisfactory. When a firm's price is greater than marginal cost, less is produced than socially
optimal and the allocation of resources is inefficient. This means that resources are reallocated
toward, from society's point of view, some other less valuable purpose.
The slope of the demand curve rests squarely on the price elasticity of demand. Marginal
revenue and price are equal if the firm's demand curve is perfectly elastic. Any determinants
which increase price elasticity force price and marginal revenue closer together, ceteris paribus.
Over longer time horizons, markets adjust to price changes and demand tends to become more
price elastic. Goods which are very expensive relative to the customer's budget are likely to be
more price-elastic than goods that are relatively inexpensive. More substitutes mean more elastic
demand. More competitors mean more elastic demand. Even though the market demand curve
is downward sloping, the existence of many competitors prevents a firm from having pricing
flexibility; the firm's demand curve appears perfectly elastic. With perfectly elastic demand the
firm maximizes profit with marginal cost pricing and achieves allocative efficiency.
But the firm's interest and society's interest do not generally coincide. Management
13
creates marketing programs, invests in research and development, encourages the design of new
products, and uses many other managerial instruments that help differentiate the firm's product
from those of competing firms. When product differentiation is achieved, buyers can
distinguish the product of one producer from that of another, and buyers develop loyalty to a
product which allows a firm to raise price without losing all of its customers. Success in
differentiating the firm's product means the firm's demand curve becomes more inelastic; the
firm becomes a price maker, not a price taker. If a firm is successful in its desire to create
customer loyalty and more inelastic demand, marginal cost pricing and allocative efficiency are
not achieved.
C. Market Supply Conditions
Basic supply conditions also impact the expected structure, conduct, and performance in
a market. Specifically, the behavior of a firm's cost curves affect long run and short run structure
and performance.
1. Long Run: Investment Decisions
The shape of the cost curves inherent in a given technology determine the structure of the
market (specifically the number of firms), as well as the long run performance in the market. As
we saw in the chapter on costs, diseconomies favor many small firms, economies of scale favor a
natural monopoly, and constant average cost results in a market being populated by firms of
different sizes. But each of these generalizations is true only if these cost conditions occur over
the total range of output. It is likely that any given market includes some combination of these
cost conditions.
Typically firms have a "U-shaped" long run average cost curve, implying economies of
scale at fairly low levels of output, constant costs for a broad range of intermediate output, and
then diseconomies of scale at higher levels of output. In such markets, the minimum efficient
scale (MES) dictates the size of the smallest firm which can survive. Dividing the quantity
demanded (at the minimum possible average cost) by the MES determines the maximum number
of firms that can compete within the market place. Of course, technological changes, specialized
product niches, cooperation among firms, and government intervention can also influence the
size and number of firms in a market.
From a social perspective, a firm's long run behavior can be evaluated on the basis of two
kinds of efficiency, and both are related to its cost structure.
(a)
Technical efficiency. If there is no way to produce a given level of output by using
resources more efficiently to achieve lower costs, then a firm has achieved technical
efficiency. This kind of efficiency is assumed in a production function, and any point on
a long run average cost curve represents a long run technically efficient combination of
resources.
(b)
Efficient investment choices. A choice which achieves the lowest long run average cost
14
for any possible output is an efficient investment choice, as well as being a technically
efficient choice. The most efficient investment choice provides the best chance for a firm
to compete or to survive a price war.
2. Short Run: Production Decisions
Once a firm has made its investment decision on the basis of its knowledge of long run
average cost, it faces a production decision. The production decision determines how much is to
be produced given certain fixed factors such as location, plant, and equipment. A manager must
maximize profits using the short run costs associated with those fixed factors. Without the
flexibility to vary all inputs, long run average cost is no longer relevant to decision making.
In short run decisions, a firm achieves the most efficient utilization of its plant if it
produces its output at the lowest possible short run average cost. A firm's long run investment
decision does not dictate the short run production decision. The long run decision provides the
best plant; the short run decision requires the most profitable utilization of that plant.
D. Efficiency and Interaction of Supply and Demand
In our review of the basic conditions in a market four types of efficiency have been
explained:
1.
2.
3.
4.
An efficient allocation of resources is achieved when a firm uses marginal cost pricing to
produce an output at which price equals marginal cost.
Technical efficiency is attained if a firm produces at lowest average cost for any given
output.
Investment efficiency means a firm produces at the global minimum of its long run
average cost curve.
Efficient utilization of plant means the firm produces at the global minimum of its short
run average cost curve.
Whether any type of efficiency is achieved depends upon the incentives implicit in the cost and
demand curves which a firm faces. The pricing, output, and profitability of the firm are similarly
dependent on supply and demand. These measures of performance differ for each of the market
structures covered in the next four sections.
EXAMPLE: BASIC SUPPLY AND DEMAND CONDITIONS FOR COPIERS
When Xerox introduced its 914 copier in 1959, there were several different copying
processes available in a $225 million market; carbon paper, small offset printing, photographic
processes, other printing processes, and even some telecommunications processes. All of these
substitutes involved complicated, slow procedures or copies of poor quality. The 914 was
differentiated from the others because it provided a simple, clear, high quality substitute. In fact,
a copy produced by any copier was frequently referred to as "a Xerox"--indicating strong product
differentiation. The new product brushed competing processes aside and established Xerox as a
15
monopoly. Since Xerox was the only producer of the Xerox machine, the demand curve of the
firm was the same as that for the market, which meant it was downward sloping.
The fixed costs associated with the supply of copiers were high, and there were
significant economies of scale to be captured. In the midvolume copier market, Jacobson and
Hillkirk suggested:
As in the low end, there is tremendous price pressure, led by Canon. The strategy is well
known: Increased market share and higher production volumes lead to more efficient
production and lower prices.iv
This suggested significant economies of scale. However, since several small firms survived in
the copier market, the economies were probably exhausted at relatively low production rates.
Let's use a hypothetical example which is consistent with initial economies of scale, but
diseconomies beyond a certain output.
The example identifies the different types of efficiency:
(a) Each plant has a different short run average cost schedule. The minimum short run average
cost for each separate plant is indicated with a star (*) in Table 4-3. Using POWEREPOINT
we can graph the average costs at different output levels as shown in Figure 4-4. The starred
items in Table 4-3 occur at the minimum of each short run average cost curve in Figure 4-4.
The minimum for each plant represents the most efficient utilization for that specific
technology.
(b) At each long run production rate the lowest short run average cost (underlined in Table 4-3)
determines which of the four plants is the technically efficient choice for that production rate.
The underlined average costs trace out the long run average cost curve in Figure 4-4. Notice
that efficient plant choice is different from the efficient utilization of the plant.
(c) The most efficient investment choice occurs at the minimum of the long run average cost
curve. Plant #4 in Table 4-3 has the lowest average cost of all plants and is therefore the
most efficient investment choice.
As the following sections will show, it is the amount of competition in a market that determines
the shape of the demand curve faced by a firm, and the allocative efficiency of a profit
maximizing firm as well.
Table 4-3 Short Run and Long Run Average Costs
16
Copiers | Short Run Average Costs for Different| Long Run
per month Plant Sizes ($ per copier)
| Average Cost
| #1
#2
#3
#4
| ($ per copier)
0 ||
2,500 | 8,800 9,500 10,000 12,000
| 8,800
5,000 | 8,000 7,400 8,000 9,500
| 7,400
7,500 | 7,500 6,900 6,700 7,800
| 6,700
10,000 | 7,400* 6,500* 6,100 6,300
| 6,100
12,500 | 7,800 6,800 5,800* 5,600
| 5,600
15,000 | 8,200 7,300 6,000 5,300**
| 5,300
17,500 | 8,700 7,900 6,400 6,000
| 6,000
20,000 | 9,400 8,600 7,600 7,000
| 7,000
22,500 |10,400 9,500 9,000 8,300
| 8,300
25,000 |11,600 10,600 10,400 10,000
| 10,000
NOTE: At each output in the left hand column, the lowest short run average cost of the four
plants marks the most technically efficient choice (underlined) and becomes the long run average
cost in the right hand column. The starred (*) items mark the most efficient utilization rates for
each plant. The long run average costs on the right hand side graphed in Figure 4-4. The long
run average cost curve is the same as the average cost curve we graphed in EXCEL in Figure 4-3
in section 1.
4 COPIER PRODUCING
Price ($/copier)
PLANTS
12
#3
#2
10
#4
#1
8
6
4
Most Efficient
Investment
(lowest point)
2
0
0
5
10
15
LRAC
(envelope)
20
25
Copiers per month (000’s)
Figure 4-4 Short Run and Long Run
NOTE: The long run average cost curve is the envelope of the short run average cost curves.
17
SECTION 3 MONOPOLY
Competition is widely believed to provide the most efficient foundation for a market oriented
economy, but for the firms and managers pursuing profit maximizing objectives, monopoly is
more rewarding. Monopoly means that there is only one firm in a well defined market and there
is no one to compete away the profitability of that market. Monopolists have the freedom to
produce any output and charge any price within the constraint of market demand.
The monopolist's freedom to choose does mean that complicated decisions must be made.
Prices cannot be pushed too low or raised too high without reducing profit. Top management
concerns itself with the science of coordinating its pricing and output decisions. Furthermore,
the monopolist's high visibility, high profitability, high prices, low output, and questionable
efficiency can provoke government intervention or even the entry of new competitors. Top
management must prepare a strategically balanced program involving marketing, controlled
visibility and, even lobbying along with its pricing decisions. Such complexity often leads to
very short sighted pricing and output decisions. Nevertheless, a monopoly has room to recover
from its mistakes, has the flexibility to achieve other goals besides profit, and is under little
pressure to change.
Who wouldn't enjoy the luxury of such a market? In fact, a doctor might locate in a rural
area so that the doctor can effectively have a monopoly. The reasons why a monopoly can
operate the way it does can be found in the structure of the market.
A. Structure of Monopoly
A monopoly is perpetuated by barriers-to-entry. Barriers-to-entry are obstructions
which prevent firms from entering a market. A competitive analysis should always cover the
barriers-to-entry that exist in a market and a strategic plan for overcoming any such barriers that
might compromise the business plan. Entry Barriers include the following:
(1)
Foreclosure of inputs or distribution channels. Other firms can be prevented from
entering a market if it is possible to foreclose some key input or distribution channel. For
example, patents or copyrights grant the exclusive rights to the owner of whatever is
covered; government confers monopoly.
(2)
Capital Constraints. To the extent that potential entrants face capital constraints, high
capital requirements can act as a barrier- to- entry to a market.
(3)
Product differentiation. Product differentiation can become a barrier-to-entry. An
entering firm must often make enormous outlays simply to pry customers loose from
their favorite brand names and get them to try a new product.
(4)
Economies of scale or economies of scope. Economies of scale can provide a cost
advantage to the market leader and economies of scope can provide a cost advantage to
the most diversified firm. As we saw in the case of the telecommunications market
18
(Chapter 8), the market leader can prevent entry simply by expanding production or by
expanding into other products. The cost advantage of either type of expansion allows
prices to be reduced and potential entrants to be intimidated.
(5)
Information asymmetries. Specialization and division of labor may provide an existing
firm with knowledge, giving it a distinct advantage over any potential entrants as well as
other market participants. Such differences in knowledge are referred to as information
asymmetry among the parties. Information asymmetries have been viewed as a major
cost impediment to perfectly competitive markets.v
Among the other important barriers-to-entry are government intervention to protect a firm, and
technological change which makes it difficult for new entrants to keep up. Barriers-to-entry
affect both short run and long run behavior.
B. Monopoly Conduct
A major branch of economics, called industrial organization, focuses on the impact of the
structural characteristics of a market on the conduct and performance in the market. In a
competitive analysis, expected behavior and performance in a market can best be analyzed after
setting the stage from the analysis of structural characteristics such as the number of firms in a
market and barriers-to-enbtry. The existence of only one firm and significant barriers-to-entry
all have implications for monopoly behavior:
(1)
Entry and exit. For a monopoly to survive, entry must be blockaded. The monopolist has
an incentive to create and maintain barriers-to-entry. But protection from entry can breed
complacency and stifle competitive instincts.
(2)
Legal tactics. Monopolists may sometimes lobby government organizations and the
court system to enhance barriers-to-entry and its monopoly position.
(3)
Invention and innovation. Important instruments for maintaining a monopoly are
research and development expenditures, patents, and copyrights. A monopolist receives
the full benefit of any research that it does; no one else is in the market. However,
without competition, there is little reason to incur costs and to turn inventions into
innovations in the market place. A new technology may threaten employee jobs and the
monopoly itself.
(4)
Marketing. Since the customer has no options, the monopolist has inadequate incentives
to drive it to meet customer needs. Complacency often characterizes a monopolist's
relationship with its customers.
(5)
Product and price strategy. Monopolists find it profitable to price too high and produce
too little from society's point of view. While such a strategy may maximize profit in the
short run, it creates the incentive for entry and may lead to lower long run profits.
19
A monopolist's complacent conduct can itself have an impact on the long run future of
monopoly. Complacency makes the monopoly vulnerable to entry by more aggressive firms
which will find a way around barriers-to-entry. Many turn-of-the-century monopolies--in
construction materials, foods, fuels, and services long ago lost their monopoly power. Most
monopolies today occur in utilities, communications, local markets, and illegal markets, or are
firms which own a unique resource or location. But even in these markets, competition is
knocking on the door.
C. Performance of Monopoly
The performance of a monopolist follows from its conduct:
(1)
Profitability. A monopolist must avoid saturating the market. Since the demand curve
from the firm's viewpoint is the same as the market demand, the demand curve is
necessarily downward sloping. The monopolist must make sure that gains in revenue
from greater production and sales offset both the losses from lower prices and the
additional costs from greater production.
(2)
Efficiency. Increased competition and market discipline lead to increased efficiency.vi
However, a monopolist is sheltered from both. It has little incentive to choose the most
efficient capital if economic profit can be earned with less efficient capital. It has little
incentive to utilize capital efficiently if economic profits can be earned with inefficient
utilization. Without the threat of competition or entry, there is little reason to be
efficient.
(3)
X-inefficiency and technical efficiency. Complacency breeds lack of attention which
leads to technical inefficiency. When a monopolist allows costs to be higher than
necessary to produce and output, then it is said to experience X-inefficiency. The Xinefficiency may take the form of gold plating in which resources are more expensive
than is necessary due to lax controls on cost. It may also take the form of wasted
resources or underemployed labor which could be more productive.
(4)
Quality of service. The inattention from complacency means customer needs may be
poorly satisfied. Because a monopolist is the only producer of a product, customers may
learn to tolerate idiosyncrasies and bad service from the monopolist because they can't
afford to antagonize the sole supplier of the service. Such tolerance means that
customers fail to communicate product inadequacies to the monopolist.
Poor
communication results in the loss of an opportunity to tailor sales and services to
customers' desires.
Progressiveness. Unfortunately much of the evidence on the progressiveness of
monopolies is anecdotal. Economists have debated the relationship of market power to
both invention and innovation, and they have not been able to make blanket
generalizations on the relationship, although diffusion is likely to occur more quickly in a
more competitive environment.
(5)
20
(6)
Equity and profitability. When monopolies earn economic profits, those economic
profits raise equity considerations. Economic profit may signal returns greater than those
required to bid the necessary resources away from competing uses. Furthermore, those
economic profits may be used to pay for lobbying and the fostering of government
policies such as protection from foreign competition.
(7)
Welfare loss to society. For the output that a monopoly fails to produce, a welfare loss to
society is measured by the difference between the demand curve, which shows what
consumers are willing and able to pay, and the marginal cost curve, which measures the
additional costs of producing more output. Because the resources are not used in the
market they seek employment in lower valued uses elsewhere and society gets fewer
wants satisfied than it otherwise might. The size of this loss has been a widely estimated
and much debated topic.vii
A monopolist’s economic profits may persist in the long run. And, efficiency is sacrificed in the
allocation of resources, choice of plant, and the utilization of plant. Price is higher, output lower,
and quality lower than what would have been expected from more competitive markets.
Government may perceive the inequities and welfare loss from monopoly and may intervene to
break up a monopoly as it did with AT&T.
EXAMPLE: XEROX AS A MONOPOLIST
Suppose that Figure 4-5 displays the run average cost curve and average revenue curve
appropriate to the Xerox's production choices. It is graphed using Powerpoint but is otherwise
the same as the EXCEL diagram in Figure 4-3.
21
PROFIT MAXIMIZATION
Price
($/copier)
14
12
LRMC
DEMAND
MR
10
8
6
4
MR=MC
2
LRAC
0
0
5
10
15
20
25
1000s Copiers per month
Figure 4-5. Locating Profit Maximizing Output (000’s copiers)
NOTE: The first order condition is satisfied at 5000 copiers where MR=MC. The second order
condition is satisfied because the marginal cost curve is rising above marginal revenue at the
point where MR=MC.
As is typical of monopoly, the profit maximizing choice fails to satisfy any efficiency
criteria. To produce between 2,500 to 5000 copiers, the monopolist chooses the most technically
efficient plant with the short run average cost curve, SRAC#2 pictured in Figure 4-4. This
represents plant #2 in Table 4-3 of the previous section. Notice that the short run average cost
for Plant #2 reaches its minimum at a production rate of 10,000 copiers. This means the firm
utilizes its plant inefficiently.
There is still more evidence of the monopolistic inefficiency in Fig. 4-3. The long run
average cost curve falls below the short run average cost curve for Plant #2. That means Plant
#2 is an inefficient investment choice in the long run. The firm would also fail to meet allocative
efficiency criteria. Price ($14,000 per copier) exceeds marginal cost ($6,000 per copier) at the
profit maximizing production rate. The economic profit is $33,000,000 per month (see
Economist's Tool Box) which may have important implications for equity and public policy.
It would generally be very difficult for outsiders to find sensitivity data like that
presented in Figure 4-5 with which to identify a monopoly's inefficiency and poor performance.
However, when a monopolist is finally exposed to competition what industry executives have to
say can be very revealing. Mike Murray, a Kodak vice president in charge of copiers gave the
22
following reasons for Kodak's successful entry into the upper end of the copier market:
First of all, technology.... Second, staying power. We had the financial resources. Xerox
and IBM knew that by price erosion we had as much staying power as they did. Third....
we didn't realize Xerox was as far behind on technology as it was; that it would take them
as long to respond as it did. Fourth, the industry, quite frankly, wanted a viable
alternative to Xerox. Kodak had the reputation. We were quite welcomed.... The rest of
it is all in execution. We had management skills. We had a solid service organization.
We had a good marketing organization. We had a very strong manufacturing capability.
(Jacobson & Hillkirk, p.89)
The structural characteristics noted above include a capital barrier to entry ("financial resources"
and the need for "solid" service organization, some unique management and marketing skills,
and manufacturing), a product differentiation barrier-to-entry (the powerful brand names of
Xerox and IBM), and rapid technological change which could serve as a barrier-to-entry for all
but the biggest of firms - like Kodak.
The quotation provides evidence of Xerox conduct which was consistent with what we
know about monopolists. Xerox had not maintained its technological lead and was "long to
respond" to Kodak's threat suggesting it had lost its ability to innovate. Finally, the quotation
suggests Xerox performance was consistent with monopoly. Implicitly, if the buyers "wanted a
viable alternative to Xerox" they may have received inadequate service or may have recognized
that they were Xerox's captives in the copier market.
Unwittingly, Xerox may actually have aided the Japanese entry to the copier market.
Xerox probably experienced substantial X-inefficiency during its tenure as a monopolist as
suggested by Joe Sanchez, a program manager for Xerox:
If we'd have known the Japanese were coming, we'd have done the 3100 [a particular
Xerox model copier] totally differently... We could have cut costs on it 40 to 50 percent if
we had done cost control.viii
With each new entry of competing firms Xerox learned how its behavior as a monopolist
position had poorly prepared it to meet the inevitable competition.
What is interesting about the information above is that it was available in 1986. Now let’s
take a look at a more recent article in the Wall Street Journal (“Xerox Faces Mounting Challenge
to copier Business” (Dec. 17, 1999, p. B4):
23
…“Xerox has the outstanding name,” says Mr. Santora , whose
company signed a $27,000-a-month leasing deal with Canon. “But opver
the past few years, they’ve kind of let things slip.”
Last week, Xerox shocked Wall Street…,citing a host of problems.
Among them: corporations putting off technology spending because of
worries about year 2000 glitches, turmoil in Brazil and a poorly executed
reorganization of its sales force.
Far down the list of reasons Xerox gave, and mentioned only briefly:
intensifying competition. Yet some analysts say that is a more serious
long-term problem for the company….
Mr. Rueppel and other analysts are focusing on rivals’ efforts to cut
into Xerox’s domination of the corporate copy machine, especially the
newer digital copiers.
These computerized copiers,…are faster and more reliable than the
old-fashioned stand-alone variety. Midrange models sell from $3,500 to
$50,000 and can spew out anywhere from 20 to 60 copies a minute.
Bigger and faster machines can cost hundreds of thousands of dollars.”…
In 1998, digital copiers accounted for about 19% of copiers sold in the
U.S. according to IDC [International Data Corporation]. But the research
firm expects digital copiers to account for 88% of the market by 2003…
Mr. Ingalls {a technology consultant] points out another treat [sic.] to
Xerox: the convergence of copiers and printers, which are now often used
for many of the same tasks.
Here we are able to confirm the basic structure of the copier markets reported by DataQuest back
in 1986 for stand alone models, but new technologies (digital copiers and computer printers) are
taking over the market and are a threat to Xerox; other companies are more efficient than Xerox
with these new technologies- just as might be predicted of a former monopolist. Furthermore,
notice how “they’ve kind of let things slip.” This kind of shoddiness also characterizes
monopolists and makes them vulnerable to entry by new firms.
From the book on Xerox in 1986 and the Wall Street Journal of 1999, we have extracted a
treasure trove of warning signs about this former monopolist. The following report by the Wall
Street Journal (“Xerox to Restate Its Results And Pay $10 Million U.S. Fine” (April 2, 2002, p.
C12)) confirms what would be predicted about a former monopolist:
The accounting scandals could not have come at a worse time. Competitors
like Canon and Ricoh had been making huge inroads into the market for superfast
copiers- a high-margin market that Xerox once dominated- while Xerox was
having little luck unseating anyone in the market for low-end printers… Xerox’s
losses were mounting rapidly; it was rapidly drawing down a $7 billion line of
credit; and for a time the company looked as if it might have to file for bankruptcy
protection…
Here we have evidence of the lack of competitiveness of its product. The fact that the unwinding
24
of a monopoly takes so long to occur is actually the opportunity for analysts and investors to use
good judgment about avoiding firms with a monopoly roots.
Graphing average revenue and average cost can be much more informative than graphing
total revenue and total cost alone. It's very easy to see total revenue as the area of a rectangle
whose boundaries are formed by horizontal and vertical lines drawn form a point on the demand
(average revenue) curve to the x and y axis. The same can be said for total cost at any point on
the average cost curve. Then, for any given output, the difference in the area of the two
rectangles represents total profit. This is demonstrated in Figure 4-5. The U-shaped average
cost curve that economists would expect can also be confirmed from such a diagram. So the
average curves can give us all the information that the total curves can provide and more!
Marginal curves can be drawn on the same set of axes as the average curves. The first
and second order profit maximization conditions are based on marginal revenue and marginal
cost. A graph like Figure 4-5 marks profit maximization where the two curves cross. That
satisfies the first order condition. The second order condition requires that the cost must be rising
at the profit maximizing output. That can be verified at between 2,500 and 5000 copiers per
month in Figure 4-5. The marginal can be used to locate the profit maximizing output. The
average curves can be used to show maximum profit.
================================================================
SECTION 4. OLIGOPOLY
25
chapter 4
26
Many firms face a situation more akin to a battlefield than a market. A few
interdependent firms- in other words, firms can that affect each others' performanceslug it out in an oligopoly. The objective of an oligopolist is often stated in terms of its
market share- the percentage of total market sales (or revenues) made by the firm. One
firm's gain in market share is another firm's loss. To further its market share goals, top
management collects information on competitors, prepares a "strategic game plan" for
survival, and learns the art of decision making under uncertainty with respect to its rival's
plans. The interactions among a few important players can be so varied and volatile that
the oligopolists receive a disproportionate amount of news coverage. The oligopolist
faces a more aggressive, noisier environment than a monopolist.
The structure, conduct and performance of oligopolies exhibit a wide variety of
forms. While many manufacturing markets are oligopolistic, the oligopolistic structure is
not the predominant structure of markets in the United States. In fact, executives in
oligopolistic markets often characterize their markets as competitive. However, while
interdependent behavior is often referred to as competitive rivalry, this is very different
from the traditional economic concept of competition that we will examine in the next
two sections.
A competitive analysis should strive to be absolutely clear about the degree of
interdependent behavior that can be found in a market if there is any. Subjective sources
of information such as the media are often quite useful to find evidence of
interdependence. Negative advertising about a competitor’s product, legal actions based
on collusion or price wars, antitrust agency involvement, and many other reported events
are rich sources of information that can be used in a competitive analysis of any
interdependence that occurs within a market.
A. Structure of Oligopoly
Many of the structural characteristics of oligopoly are similar to those of
monopoly,and barriers-to-entry originate from the same sources for monopoly. However,
while barriers-to-entry blockade entry in monopoly, entry is possible, though sometimes
difficult, in oligopoly.
B. Conduct of Oligopoly
The importance and interdependence of a few major players results in a variety of
oligopoly behavior, and economists have developed a wide variety of models to explain
that behavior. Oligopolistic conduct is marked by interdependence as firms maneuver for
strategic advantage over each other:
(1)
Mergers and joint ventures: Given their interdependence it is in the oligopolists
interest to cooperate and avoid intense rivalry. Since they are often barred from
even informal cooperation due to antitrust considerations, they may resort to a
formal organizational relationship with mergers or joint ventures. There are three
types of mergers: (a) horizontal, (b) vertical, and (c) conglomerate mergers.
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The horizontal merger involves the linking of two firms which compete
in the same market. The horizontal merger allows the merging firms to take
advantage of economies of scale and the possibility of eliminating competitors.
The vertical merger links buyers with sellers. Backward vertical integration
involves the entry of a firm into the markets populated by its suppliers, while
forward vertical integration involves entry into the markets served by its
customers. Firms can often gain strategic advantages from vertical integration.
Vertical integration ensures stable sources of supply or distribution for an existing
firm but raises the costs--and perhaps even forecloses resources or distribution-to potential entrants.
Complementarity and economies of scope provide the rationale for many
companies to become conglomerates which are firms that produce in more than
one market. Conglomeration may allow an oligopolist to cross-subsidize, using
profits from one market to subsidize activities in another. Such flexibility may
daunt competitors. Furthermore, when firms face each other in multiple markets,
the possibilities for retaliation increase. Mutual forbearance- the unwillingness
to compete aggressively when firms face each other in many different markets- is
the result.ix
There are three types of conglomeration: market extension, product
extension, and pure conglomerate expansion:
(a)
Market extension occurs when the same product being delivered into
different markets- most often according to geographically determined
market boundaries. Market extension permits advantage to be taken of
any economies of scale that might exist in producing or marketing a good,
early information about competitive developments in other markets, and
learning effects from experimenting in different markets. It also prevents
potential competitors from gaining a toehold in other markets.
(b)
Product extension is expansion into closely related markets with very
similar products. Potential entrants are likely to come from producers of
substitutes, complementary goods, and goods which can be produced
together with accompanying economies of scope.
(c)
Pure conglomerate expansion occurs when a firm enters markets totally
unrelated to its own. While some economies of scope may result from
such conglomeration, there are often offsetting diseconomies from
excessive management burdens.
These different ways to formalize cooperation may bestow a strategic
advantage to an oligopolist through economies of scope, economies of scale,
elimination of a competitor, cross subsidization, foreclosing resource
accessibility, or foreclosing distribution channels.
(2)
Pricing Policy: In an oligopoly, firms are interdependent. A change in price may
trigger a retaliatory response by competitors which shifts a firm's demand curve.
A price war can erupt which results in retaliatory price moves that drive prices to
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levels at which some firms must exit. A dominant or powerful firm may
deliberately employ predatory pricing to set prices below long run equilibrium
levels to force weaker competitors out of the market and then to gain long run
profit after they leave. Many oligopolies use limit pricing to keep prices low
enough to forestall entry.x
Such low profit outcomes provide an incentive to collude. The most overt
form of collusion is conspiracy, which involves explicit agreements and planning
among competitors concerning product pricing or the assignment of territories.
Tacit collusion occurs when firms adopt a pattern of responding to each other in a
market to fix price or output without consulting each other. Price leadership is a
form of tacit collusion in which all of the firms follow a single firm in setting
price.
Over its history, an oligopoly may experience one form or a variety of
forms of such interdependent pricing.
(3)
Product Policy: The interdependence among firms in an oligopoly means that
firms react to their rivals' quantity, as well as price, decisions. Such
interdependent reactions violate the ceteris paribus assumption required to
measure a firm's demand. A firm may face a complicated, strategic pattern of
demand shifts as competitors react to its price and product decisions.
(4)
Non-Price Competition: When firms are intensely interdependent, price changes
become a powerful symbol of intentions. To avoid price wars, firms may avoid
altering price and choose to compete in other ways. A firm may be able to
enhance the quality, servicing, advertising, or delivery of a good without changing
its price. Product improvements and product differentiation become an important
source of non-price competition in oligopoly. As in price competition, rivals are
likely to react when such non-price competition proves effective.
Interdependence requires careful consideration of the impacts on competitors and the
reactions of competitors to the use of any managerial tool available to a manager.
C. Performance of Oligopoly
Oligopolies suffer from some of the same problems as monopoly. The oligopolist
is still not necessarily at the minimum of the long average cost curve which means it may
choose inefficient technologies. Nor does the oligopolist necessarily utilize its plant and
capital efficiently; barriers-to-entry may prevent the discipline that would force a firm to
produce at the minimum of its short run average cost curve. Allocative efficiency is not
achieved because price exceeds marginal cost. Price is still too high and production,
therefore, is still too low. Economic profit can be expected in the long run. Because of
non-price competition, oligopolists are likely to perform better in customer-service and
be more aggressive in pursuing technological change than monopoly.
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If there are firms waiting to enter the market, an oligopolistic market becomes a
contestable market.xi If entry is easy, quick and efficient the threat of potential entrants
can compel oligopolists to hold prices near the minimum of long run average cost. If so,
the market is a perfectly contestable market and the oligopoly makes efficient capital
choices, uses the capital efficiently, and uses other resources efficiently. Furthermore,
the resulting lack of long run economic profit, the lower prices, and the high output levels
mean the elimination of welfare losses.
EXAMPLE: XEROX AS AN OLIGOPOLIST
IBM entered the upper mid sized copier market with its MODEL III. Then Kodak
entered. The Japanese invaded the market with Canon, Ricoh, Minolta, and Sharp. The
upper mid-sized copier market had become an oligopoly.
A. Pricing Policy
With market power and discretion to set prices, an oligopolist may resort to a
rule-of-thumb to determine the best price. Often a markup is applied to certain explicit
costs to arrive at the price. A markup is the percentage by which price exceeds a firm's
unit (explicit) cost. One Xerox executive, Lyndon Haddon, described markup pricing
strategies in the copier market:
The Europeans would be very happy with a three times mark up ... Americans
would try to figure out a way to make it four times. And the Japanese would cut
their price in half and sell four times as much.xii
Haddon is saying that oligopolists use their price discretion very differently, and these
differences can be traced to intangible character, cultural, and historical backgrounds.
Let's see how differently the oligopolists from the three nationalities might set
price and output under the same demand and cost conditions. Let's borrow the data on
long run average cost in Table 4-3. Assume that explicit costs constitutes half of the
average cost, as suggested by the dashed line in Figure 4-6. The markups above the
explicit cost appear in Figure 4-6 and reflect exactly Haddon's description of pricing
strategies:
(a)
By producing only 2,500 copiers per month, the Americans would force the price
up to $22,000 apiece. Since the average explicit cost of each copier is $4,400 at
this output, the price includes a 400% markup over explicit unit cost.
(b)
Insisting on a lower 300% markup means that the Europeans are willing to
produce more (up to 5,000 copiers) at a lower price ($14,000 apiece).
(c)
However, the Japanese are willing to produce "four times as much" at 20,000
copiers. Their explicit unit cost is $3,500 and price slides down the demand curve
to $7,000 which gives them only a 100% markup.
By increasing output, a firm would cause price to be lower. But which solution is the
profit maximizing solution?
Figure 4-6 Alternative Optimization Strategies (000s copieres)
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OLIGOPOLY MODELS
Price ($/copier)
25
Average Explicit Cost
20
Long Run Average Cost
american choice Demand
15
10
5
0
{
4X european choice
{ {
{ 3X {
{ {
0
5
10
japanese choice
{
1X{
15
20
25
1000s Copiers per month
NOTE: Market power allows different choices.
The tendency to price differently would be fine if the Americans, Japanese, and
Europeans each had a monopoly over the copier markets in their respective countries.
But if all three were competing in the same copier market, the law of one price says that
only one price prevails. That price will be the lowest price (the Japanese in this case).
The law of one price makes the firms interdependent and they must now adjust to each
other in their pricing policies. Jacobson and Hillkirk describe the eventual pricing
environment in the oligopolistic copier market:
In the seventies, you could track Xerox, Kodak, and IBM within ninety
days of each other on copier price changes. If Xerox raised prices 5 percent, so
did the others. There was no collusion, but each company was well aware of the
others.xiii
This is classic interdependence. If a firm tried to move up or down its demand curve, the
other firms would follow.
B. Non-Price Strategies Driven by Interdependence
Interdependence has driven copier firms to gain strategic advantages over
competitors through non-price competition and by invoking government intervention.
Jacobson and Hillkirk describe the Xerox reaction to IBM's first entry into the copier
market on April 22, 1970:
The same April day Xerox sued IBM, charging infringement on twentytwo patents. ...
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... it was a period increasing litigation, increasing competition and stagnating
product development... Hundreds of millions of dollars were going into product
development and very little was coming out....
Instead of product announcements, you were more likely to read in the
newspaper headlines such as: "Xerox Sued Again." In 1972, the FTC accused
Xerox of illegally monopolizing the office copier business....
... "There is no question in my mind that the FTC and... [other] cases did
absolutely impact our pricing policies," Xerox chief executive David Kearns says.
"We were not as aggressive as we should have been." Kearns thinks Xerox kept
its prices up too long, creating a perfect opportunity for its competition to gain
market share.xiv
Obviously, barriers-to-entry were not high enough to exclude entry. The battles around
patents and antitrust are typical of oligopolies.
In spite of the claim of "competition", the quotation confirms the "market share"
goal that so often is used to monitor the success of the firms in an oligopoly. While the
quotation suggests that the lack of aggressive pricing tactics was due to the antitrust
agencies [FTC], the first part of this example suggests Xerox might not have been very
aggressive in pricing, even without its government difficulties.
The quotation also points to the crucial role of product development- an important
form of non-price competition. As a monopolist, Xerox had product development
characterized by X-inefficiency, but as an oligopolist it would be forced to be more
technologically innovative. The man responsible for turning Xerox around, and who was
quoted in the article, was CEO David Kearns. Let's hear what he had learned in turning
Xerox around:
I've never quite understood why it's taken American business so long to
grasp the importance of quality.... quality can be precisely measured by the oldest
and most respected of measurements in business: Profit.... You might think it
costs more to make a better product because it takes more time and energy. But,
in the end, the costs of making that product better are actually lower because you
don't have to go back and fix the defects. In other words, the cost of quality is
more than offset by the gains of doing it right the first time.xv
Xerox had to focus its production and technological change on "quality." Xerox was
eliminating the X-inefficiency of its monopoly days in order to compete effectively with
new entrants. Kearn's message on quality and his success with Xerox were recognized by
President George Bush (I). David Kearns was appointed the Secretary of Education in
the First Bush administration.
But the troubles at Xerox did not end. Kearn’s discovery of quality was not
adequately implemented by Xerox. As a result the market worked in favor of its
competitors. In 1999 the Wall Street Journal (Dec 17, 1999, p. B4) reported:
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In 1998 in the U.S., Xerox was the No. 1 seller of black-and-white digital
copiers, with 37% of new copier sales… But many analysts say Canon, which
ranked No. 4, could take the top spot this year.
Richard Norton, president of DocuTrends, a Saratoga, Calif., consulting
firm, is one. “they just went gangbusters,” he says, despite the fact that Xerox
had been in the market with digital copiers a couple of years before Canon.
“Xerox shouldn’t be ending up in second place.”…
Gil Hatch, president of Xerox’s office-systems group, says …internal
projections show Xerox’s share had risen to the mid-40% level. In the second
half, however, he says the company felt the impact of new competition. Mr.
Hatch says second-half market share will slip slightly, especially in the higherend printers that make 60 to 92 pages a minute. But he says that’s because the
company had such a dominant grip, with more than 60% of the market.
By the way, this kind of reporting is the reason that the Wall Street Journal (WSJ) so
dominates all other business reporting. From reading the quotations so far, you can see
not only the structure of the copier market, but the firms that report on the copier market.
You can also find excellent information on the different segments of the copier market
(eg. “higher-end” etc.) and the market shares of the key players in these segments. The
WSJ carefully documents its information. Most importantly, the Wall Street Journal is
providing a competitive analysis in the form of a story- the best kind and most interesting
form of competitive analysis. Facts are only presented to highlight the crucial aspects of
the story that is being told about the interdependent behavior of the oligopolistic copier
market.
SECTION 5. MONOPOLISTIC COMPETITION
There are many firms in truly competitive markets. And none of the firms have
much- if any- market power. Such markets are not the material for frequent dramatic
headlines about big corporate decisions on pricing or production, as in oligopolies or
monopolies. Nevertheless, newspapers devote whole sections to reporting the price
performance (financial market data) and advertising (want ads) for competitive markets,
and these markets generate the largest part of employment and the gross national product.
Unlike oligopolies, competitive markets uniformly exhibit quite predictable
structure, conduct and performance. There are two different types of competitive
markets, purely competitive and monopolistically competitive markets. The difference
between the two is determined by the nature of the product. If customers cannot
recognize which of many firms produce a specific good, then the good is standardized
and the firms have no ability to alter price- none of them are important enough or have
the market power to do so. However, if the market is characterized by product
differentiation, then a firm may be able to gain some market power by building consumer
loyalty.
When there is product differentiation a competitive market is called
monopolistic competition.
A. Structure of Monopolistic Competition
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Product differentiation is the key characteristic which enables a market with many
buyers and many sellers to be classified as monopolistic competition. Product
differentiation generally does not become so strong that it becomes a formidable barrierto-entry; there are too many firms and a large variety of preferences to be met in the
market place. Other barriers-to-entry are small or nonexistent.
Product differentiation makes a market demand curve hard-if not impossible- to
define; products are not homogeneous and indistinguishable from each other. To the
extent that a firm is successful in creating product differentiation, it acquires a niche of
loyal customers and the market power to alter prices to those customers; the demand
curve from the point of view of each firm is downward sloping.
B. Conduct in Monopolistic Competition
The only source of market power for monopolistic competitors is product
differentiation. Managers strive to differentiate their product and to build customer
loyalty. To gain customer loyalty, they develop marketing strategies, provide extra
services, ensure quality, adopt the latest techniques, and do everything possible to
develop customer goodwill. Much of managements' time is spent worrying about the
image of their product, and copying the fads and successes of related products.
Since barriers-to-entry are low, one of the best indicators that a market is
competitive is the frequency with which entry and exit occur. With frequent entry and
exit, monopolistically competitive firms are less likely to engage much in the price wars,
collusion, or other examples of interdependent behavior that are so common in oligopoly.
Any new entrant can undercut any deal between existing firms, and success in
eliminating one rival only results in a new entrant to take its place.
Whenever existing firms earn economic profit, the signal goes out to resource
owners and entrepreneurs to enter the market, driving the demand curves of existing
firms further to the left. If the demand curve is driven to the left of the long run average
cost curve, exit occurs. In the long run, the dynamics of entry and exit force
monopolistically competitive firms to a price which equals long run average cost.
C. Performance in Monopolistic Competition
Customer loyalty allows firms to charge higher prices and different prices. When
a market is characterized by many different prices charged by many different firms it is
probably monopolistic competition. Customer loyalty also gives firms market power.
With a downward sloping demand curve the firms do not practice marginal cost pricing
and therefore are not allocatively efficient and are not likely to pick the most efficient
investment choices.
While the firm expects to produce profitably with its investment choices, entry of
new firms always prevents demand from being great enough to utilize capital most
efficiently. Entry drives a firm's demand curve against the long run average cost curve
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which means (since P = ATC) that economic profit is zero in the long run even when
profit is being maximized. Because a firm is driven against its long run average cost
curve without being at its minimum, it cannot be at the minimum of its short run average
cost curves either; instead, there is chronic excess capacity.
When consumers choose greater variety, even in the face of the resulting higher
prices, the monopolistic competition model describes conduct and performance. In this
model, consumers decide the tradeoff between efficiency and variety, in favor of variety.
EXAMPLE:
MARKETS
XEROX
IN
MONOPOLISTICALLY
COMPETITIVE
COPIER
In the seventies, the copier market became even more crowded. Jacobson and
Hillkirk described of the development of the midsized market:
Canon was expanding its factories and strengthening its marketing to make a run
at the leader. The Japanese were no longer content to control the low end. They
began moving up market. For the first time, Xerox began seeing national
television ads for copiers from the Japanese companies themselves. The pace of
competition accelerated. Between 1971 and 1978, seventy-seven different plain
paper copiers were introduced in the United States. From 1978 to 1980, another
seventy were introduced.
Advertising by the Japanese entrants appears to be critical here. Advertising creates
buyer awareness and even identification with a product. Such brand awareness is a form
of product differentiation, as the buyer learns to differentiate the outputs of one firm from
those of others.
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Figure 4-7
MONOPOLISTIC COMPETITION
Price
($/copier)
12
LRMC
10
LRAC
8
6
Demand
4
Long Run Profit
Maximizing Output
2
0
0
5
10
MR
15
20
25
Copiers per month (000s)
NOTE: In the long run, monopolistic competition yields zero economic profit. Firm
demand is forced leftward to the long run average cost curve.
Figure 4-7 provides an example of the long run position of the demand curve for a
monopolistically competitive copier company. We have assumed that the market has
expanded so much that there is room for many firms and that there are many potential
entrants. Because of product differentiation the demand curve facing the firm slopes
downward, but the firm has less market power than it would as an oligopolist or
monopolist. Unlike monopoly or oligopoly in the long run, entry forces the demand curve
to the left until it is barely possible to eke out a normal rate of return, which is the same
as saying that the firm earns zero economic profit.
Because it is not at the minimum of the long run average cost curve, the firm has
not chosen the least cost plant. Reviewing the four plants in Figure 4-4 in section 2, we
can see that the firm selects the lowest short run average cost curve (SRAC3) at a
production rate of 10,000 copiers per month. However, the firm is prevented from
expanding enough to use the capital most efficiently because its demand curve is to the
left of the minimum of the short run average cost curve; it is underutilizing its plant
which means it is producing less than the output at which minimum short run average
cost is achieved.
Any production level other than 10,000 copiers results in losses. While the
monopolistically competitive copier firm makes no long run profit, it still charges a
higher price than the minimum possible long run average cost.
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SECTION 6. COMPETITION.
Competition is not characterized by the complacency of monopoly or the
interdependence and aggressiveness of oligopoly. Only when product is standardized can
a market with many buyers and sellers be considered purely competitive. Standardized
product results in bigger differences in conduct and performance than would occur with
product differentiation in a monopolistically competitive market. This one difference in
structure means that managers find profit maximization is equivalent to cost
minimization because they have no loyalty or market power. The single minded, cost
cutting mentality of competition is quite distinct from the goals and discretion of
managers in markets where market power can be exercised.
A. Structure of Competition
Since firms in perfectly competitive markets have no market power, any hold that
the competitive firm tries to have on buyers can be washed away by the competition from
the rest of the market. The structural characteristics of the purely competitive market
which prevent the development and exercise of market power include:
(1)
(2)
(3)
(4)
(5)
Large Number of Firms: When there are many firms in a market, the customer
always has alternatives to a single firm's product or service.
Low Barriers to Entry and Exit: Even when there are only a few firms in the
market, the threat of entry and exit limits the price that a firm can charge. If entry
is restricted then the market price does not fall enough to eliminate economic
profit. If inefficient firms are not forced to exit, they continue to serve customers
and make it harder for efficient firms to reach those customers. Both barriers-toentry and barriers-to-exit must be low in order to allow the threat of entry and exit
to establish discipline in the market.
No transaction costs or restrictions on movement of resources: Customers have
no transaction costs, lags, or difficulties in changing from one supplier to another.
Similarly resources can be moved quickly and with low cost. Finally, companies
can move in and out of the market with low cost as well. If resources are not
mobile, then substantial lags and costs can prevent timely competitive entry into a
market. If transactions costs are large, customers may simply be unwilling to
change to more economical sources of supply. Furthermore, high transaction
costs may prevent sellers from filling potentially profitable market niches.
Standardized Product:
The output of any one producer is functionally
indistinguishable from that of any other producer.
Perfect Information: Consumers can easily inform themselves about product
prices. Resource sellers are well informed about alternative employment.
Competitors can find out easily where economic profits are being earned and can
use the least-cost technology to produce the product. These conditions allow
entry and exit to be timely and efficient. No compromise in behavior is required
due to competitive disadvantages in obtaining information. If information is not
perfect, then entrants may not be able to learn the technology nor find out about
opportunities.
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These structural characteristics eliminate a firm's pricing discretion; prices are determined
by the market forces of supply and demand.
B. Conduct in Competition
From the standpoint of a competitive analysis it is often valuable to provide a
subjective picture of the interaction among market participants. We saw in the case of
oligopoly that subjective examples of interdependence (eg. collusion, price wars, etc.)
were dead giveaways to the existence of oligopoly. By contrast, the cooperativeness of
purely competitive companies in helping each other is evidence of their powerlessness to
affect each other through price wars or any other rivalrous market behavior… so they
help each other. That atmosphere of cooperation (without collusion) is an important
hallmark of perfect competition.
Market supply and market demand determine the price in the market place. In the
models of previous sections we have focused on a given firm's view of demand and
average cost, with the implications for marginal revenue and marginal cost, because each
firm had some discretion over the price it would charge. However, in a purely
competitive market, the demand curve, from the point of view of a firm, is flat which
means it is a price taker.
Although a competitive firm has no control over price, it does control how much
output it produces. The fact that price remains constant regardless of how much the
individual firm produces, means that a firm always knows precisely what marginal
revenue is; it is equal to the market price. Because it produces up to the point where
marginal cost equals price, a purely competitive firm is using marginal cost pricing. In
pure competition marginal cost pricing is a simple, workable rule-of-thumb by which to
maximize profit.
Marginal cost pricing identifies the output that a firm is willing and able to supply
at alternative prices, and therefore, the marginal cost curve consists of the same pricequantity combinations as the firm's supply curve. Only when a purely competitive firm
must shut down is marginal cost no longer equal to supply. In the short run a firm can
find itself in one of three situations:
(1)
Supply with positive or zero economic profit: When price is equal to or greater
than average total cost, there are no losses because total revenue equals or exceeds
total cost.
(2)
Supply with losses: Although a firm incurs losses, it may continue to produce the
quantity indicated by marginal cost pricing. As long as the price covers average
variable cost, each unit produced makes a contribution toward the firm's fixed
cost. The firm would incur a greater loss if it shut down, because it would receive
no revenue and it would still incur all of its fixed cost.
(3)
Shut down with losses in the amount of fixed cost: When price is lower than the
average variable cost, the firm loses more by producing than it loses if it produces
nothing. For this reason it is better to shut down than to produce.
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Average cost and average variable cost are the key to the firm's supply choices.
In long run decision making, all factors are variable, and a firm can choose a
different plant, a different location, a different technology, expansion, contraction, entry,
or exit. The variability of all factors eliminates fixed cost from consideration. As a
result, at a zero output level there may be zero costs, and when a firm exits, there are no
costs. Furthermore, average variable cost is identical to average total cost, and there are
only two possible long run situations for a firm:
(1)
Profitable supply: If the market price is at or above the lowest point on a firm's
long run average cost curve, the firm earns at least a normal profit and stays in
business.
(2)
Exit: If the market price is below the lowest point on a firm's long run average
cost curve, the firm should exit.
The minimum of the long run average cost curve divides the long run marginal cost curve
into two segments. Above the minimum, the long run marginal cost curve represents the
firm's long run supply curve; below that point, the supply curve runs along the y-axis,
which means that output is zero.
Because firms enter and exit from the market, the market supply curve should
shift until the competitive equilibrium is established. In other words, the equilibrium
must occur where price just covers the minimum long run average cost for producing a
good; where no further incentive for entry or exit exists. As long as all of the firms in the
market face the same long run average cost curve the price should remain at the
minimum long run average cost.
C. Performance in Competition
With price at the minimum of the long run average cost curve, very favorable
performance can be expected from a market. There is no way to get price any lower
without some firms being forced to exit from the market. Since price is forced to the
lowest possible level, the quantity demanded is, similarly, as great as can be profitably
supplied.
When price is at the minimum of the long run average cost curve, three kinds of
efficiency are achieved:
(1)
Efficient allocation of resources: At the minimum of the long run average cost
curve, marginal cost, average cost and price are all equal. When price equals
marginal cost, this gives the correct signal for allocating the resources among
competing uses. From society's viewpoint resources are fully utilized and
rewarded with the compensation minimally required to bid those resources away
from competing uses.
(2)
Efficient investment choice: The long run average cost curve represents the least
cost combination of resources for producing every output. Therefore, the plant at
the minimum point of the average cost curve is equivalent to the choice of the
most efficient, least-cost plant for the competitive firms' long run equilibrium
output.
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(3)
Efficiency in utilizing plant: Since no short run average cost curve can fall below
the minimum of the long run average cost curve, a firm must be at the minimum
of the short run average cost curve when it is at the minimum of the long run
average cost curve. The plant is operated at its optimum rate.
When competitive forces drive prices to the minimum of the long run average cost curve,
it assures that all three types of efficiency are achieved. Technical efficiency is achieved
as well since the firm is on its average cost curve.
Finally, in the long run, the competitive firm earns only normal profits, which
means zero economic profit. As in the case of monopolistic competition, the firmdemand curve is just tangent to the long run average cost curve.
EXAMPLE: A COMPETITIVE COPIER MARKET
Since it is generally possible to tell who produces a given copier and because
brand names of copiers are familiar enough to be recognized by most customers, the
copier market has never become purely competitive. However, the low-end segment of
the market may approach the competitive model. Business Week reported by the mideighties "Copiers have turned into generic office equipment that yields low margins of
manufacturers."xvi An IBM spokesman provides evidence of standardization:
There's no loyalty in the copier market today. A customer will sign a
contract with IBM today. At the end of three years, if we don't continue to be the
best-priced performer, we're going to be out. That's what happens, It's very
tough, very demanding. Close your eyes for two seconds and you lose.xvii
As machines become increasingly "generic", product differentiation makes less
difference. This suggests that the lower end of the copier market may approach a purely
competitive market.
To see how profit is maximized in the long run, we can use the cost data to see
what would happen if Xerox were a price taker and a competitive market forced prices
down to the minimum of long run average cost. From the long run average cost curve
(Figure 4-8 and Figure 4-4), the minimum long run average cost is $5,300. The market
price has a tendency to move toward this level:
(a)
If the market price falls below $5,300 firms would exit from the copier market
because of economic losses, causing a leftward shift in market supply which
would eventually force the equilibrium price back up to $5,300.
(b)
If the price rises above $5,300 firms would be induced by attractive economic
profits to enter the market, causing a rightward shift in market supply which
would eventually force the equilibrium price back down to $5,300. As the market
price falls firms with inefficient technology must exit in favor of the entry of
firms with a more efficient technology.
The minimum of the long run average cost curve marks long run competitive equilibrium.
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Figure 4-8. Entry and Exit in Competition
COMPETITIVE EQUILIBRIUM:
THROUGH NATURAL MARKET FORCES
Price ($/copier)
Price ($/copier)
12
LRMC
10
SUP
PLY
8
6
LRAC
4
DEMAND
0
2
0
1 BILL 2 BILL 3BILL 0
Copiers per month
MARKET
5
10
15
20
25
1000s Copiers per month
FIRM POINT OF VIEW
NOTE: Entry and exit force price down to the minimum of the long run average cost
curve in the long run.
In this case the competitive equilibrium would be achieved at 15,000 copiers per
year where marginal revenue (=price) equals long run marginal cost. From Table 4-3, we
can see that plant #4 (graphed in Figure 4-8) is the only technology which can be used to
produce copiers at such a low price. This plant achieves:
(a)
The most efficient investment choice (there is no lower point anywhere on the
long run average cost curve).
(b)
A technically efficient choice because the price/quantity combination falls on the
long run average cost curve.
(c)
An efficient utilization of plant because Xerox can be at the minimum of its short
run average cost curve for plant #4.
(d)
An allocatively efficient use of resources because price equals marginal cost in
the long run.
Since we have used the same long run average cost curves for each of the different
market structures, we can see that none of them achieve lower prices, greater quantity, or
lower profit than this choice. From a social standpoint, the minimum of the long run
average cost curve marks the most desirable output level.
Xerox remade its corporate culture around the idea that it would fight the
Japanese. However, as the Japanese penetrated the low end of the copier market, Xerox
had to change; in the low end of the market it linked up with Sharp.xviii Xerox recognized
that the long run battle could only be won with a full product line of complementary
office products, and it had to link up with its adversaries to provide that full copier
product line efficiently.
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SECTION 7. SUMMARY
Market structures undergo dynamic changes. Xerox moved from a monopoly
position towards pure competition in the low end of the market. As the environment
became more competitive, it had to lower its prices, market more intensively and
innovate more aggressively. Its failure to do so in the early years made it vulnerable to
competition. AT&T (chapter 8) and Boeing (chapter 2) shared similar transitions. But,
the transition can also work the other way - from more competition to less competition as
in the oil (chapter 3), auto (chapter 5), and airline markets (chapter 6).
These changes mirror underlying changes in conditions of supply and demand in a
market. The shape of the average cost curve determines the size of the most efficient
firms. The shape of the demand curve and product differentiation determine market
power and the desirability of using marginal cost pricing. The interaction of demand and
supply determines the number of firms that are likely to survive in the market.
Changes in the basic market conditions also affect firm conduct and performance,
and the unit costs at which four different types of efficiency are attained:
(a)
(b)
(c)
(d)
Technically efficient choices: The least cost plant size for any given output level
and technology occurs along the long run average cost curve. X-inefficiency of
some monopolies violates technical efficiency.
Allocative efficiency: When marginal revenue (and therefore marginal cost) is
below price, a profit maximizing firm with market power is not using resources in
society's best interest. Only in pure competition can we identify how market
forces lead to allocative efficiency.
Efficient investment choices: The lowest point on the long marks the most
efficient size of plant. Purely competitive markets provide the discipline required
to force such efficient long run choices.
Efficient plant utilization: For any given technology or plant size, efficient plant
utilization occurs at the production rate at the minimum of the short run average
cost curve. Monopolistic competition results in chronic excess capacity. Firms
with market power are not likely to be operated at the minimum average cost.
A purely competitive firm can survive only when all four types of efficiency are
achieved. Because of competition, they provide the quantity at the lowest price, without
generating sustainable economic profit.
Because of different underlying conditions, profit maximization means quite
different behavior for differently structured markets. A monopolist can become
complacent because of the lack of competition. However, the environment may provide
a false sense of security and complacency which may encourage entry. In an oligopoly,
interdependence can lead to conspiracies, to price wars over market share, and non-price
competition may become a major instrument for achieving firm goals. In monopolistic
competition, the managers must differentiate their product and develop customer loyalty
and goodwill. This means they are frequently image conscious and use expensive
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innovative marketing programs. In pure competition, the managers are extremely cost
conscious, because minimizing cost is equivalent to maximizing profit. In each market
profit maximization results in dramatically different behavior.
In this chapter it has been possible to perform four different competitive analyses of
one industry- the copier industry- at different stages in a product cycle. At each stage of
its development, a story has been told, based on one cost structure but many changes in
demand. From these demand changes, the structure, conduct and performance in the
market have been described. However, there is no one way to organize the competitive
analysis of a given market or industry. The story should dictate the structure of the
competitive analysis. The basic conditions of supply and demand, the structure, conduct,
and performance are players in that story which are to be used to show your command
over and ability to survive in the market.
BIBLIOGRAPHY
The four structural models of this chapter are the cornerstones of pricing theory,
which was the traditional focus of economics courses. Principles of economics and
theory texts provide examples and motivate a simple graphical presentation with simple
arithmetic calculations and basic definitions. Intermediate Microeconomic Theory books
describe the models algebraically or with calculus, examine special cases, and develop
the full economic implications of the models.
The traditional undergraduate and graduate level textbooks in Industrial
Organization theory explore the regulatory and antitrust implications of the structureconduct-performance relationships within each type of market. One of the readable
undergraduate textbooks in industrial organization is:
Don E. Walman and Elizabeth J. Jensen. Industrial Organization: Theory and
Practice, 2nd edition Boston: Addison Wesley 2001
THE comprehensive, advanced graduate text in this field is:
F. M. Scherer and David Ross. Industrial Market Structure and Economic
Performance. Boston: Houghton Mifflin Co., 1990.
The Scherer book is non-mathematical and well written; much of it is within the grasp of
the general reader.
Several of the following sources concerning specific topics may prove valuable:
MARKET DEFINITION: Issues concerning market definition, market boundaries, and
market extent are covered in:
Peter O. Steiner, "Markets and Industries" in the International Encyclopedia of the
Social Sciences (New York, NY: The Macmillan Co. & the Free Press, 1968).
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F. M. Scherer & David Ross, Industrial Market Structure and Economic
Performance, 3rd ed. Houghton Mifflin Co., Boston, 1990. (pp. 73-76)
EMPIRICAL VERIFICATION OF STRUCTURE-CONDUCT-PERFORMANCE
(SCP). An excellent source to capture the flavor of the original controversy over the
validity of the SCP paradigm is:
Harvey J. Goldschmid, H. Michael Mann, J. Fred Weston. Industrial
Concentration: the New Learning Little, Brown & Co., Boston: 1974
COMPETITION. The mathematical exposition of pure competition and monopolistic
competition models are found in many principles economics textbooks. For a history and
critique of theses models again see Scherer (Chapter 2) and:
G. C. Archibald. "Monopolistic Competition" in The New Palgrave, Eatwell et.
al. eds. London: The Macmillan Press Ltd., 1987
In general, the Palgrave is an excellent source for background on the different economic
models. Under the "competition" category, the Palgrave has articles on the Austrian,
classical, and Marxian conceptions of competition. It also elaborates on the distinction
between competitive rivalry and the current widely accepted view of competition.
Extensive references can be found in the Palgrave.
Many popular books tell of the transitions from one type of market structure to
another. Books about IBM, AT&T, RCA, oil companies, drug companies, hospitals and
steel companies could have provided the examples for this chapter without changing the
chapter outline. A different story emerges in books about electronic equipment, auto, and
financial services markets, which started competitively, became oligopolies, and, with
the internationalization of the market, move again towards a highly competitive
environment.
DEFINITIONS:
Barriers-to-entry (BTE):
Obstructions which prevent firms from entering a market.
BTE include foreclosure of inputs or distribution channels, capital constraints, product
differentiation, economies of scale, economies of scope, information asymmetries,
government intervention (patents, copyrights, and other grants of monopoly), and rapid
technological change.
Competition: A market with many buyers and many sellers in which no firm has any
market power. In monopolistic competition there is product differentiation. In pure
competition output is standardized across the firms in the market. In both markets, entry
and exit are easy and there are no asymmetries in information.
Competitive rivalry: The interdependent, battling of firms for market share.
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Conglomeration: The diversified expansion into businesses in non-related markets.
Conglomerates are firms that contain businesses in many different markets.
Contestable market: A market in which there are low barriers-to-entry and potential
entrants can enter quickly, easily and efficiently.
Cross-subsidize: Using profit from a subsidiary in one market to subsidize a subsidiary
in another market.
Efficient Allocation of Resources: If at the profit maximizing output price equals
marginal cost then the firm is efficiently allocating the resources.
Efficient Investment Choice: The production rate at which the lowest possible long run
average cost is achieved.
Efficient Utilization of Capital: A firm utilizes capital most efficiently when it
produces at the production rate corresponding to the lowest short run average cost.
Equilibrium (competitive): The intersection of market supply and demand at a price
which corresponds to the minimum of the long run average cost curve of firms within the
market. When price falls to the minimum of long run average cost there is no further
incentive for entry or exit.
Information asymmetry: A situation in which information can be obtained by some
individuals or organizations but which is more expensive or blocked from others. Uneven
access to information.
Interdependent: When two or more firms have the ability to affect each others'
performance.
Law of one price: only one price can be maintained in a market, and that is the lowest
price that is offered.
Limit pricing: Setting prices low enough to prevent potential competitors from entering
a market.
Marginal Cost Pricing: Producing up to the output at which price equals marginal cost
and maximum profit is achieved.
Market power: The ability to influence market outcomes; a downward sloping demand
curve from the point of view of the firm indicates market power.
Mergers: When two or more formerly independent companies come under common
control. Horizontal mergers join firms that have previously competed with each other in
the same market. Vertical mergers join a buyer and a seller. Market extension mergers
join companies that produce the same product but in different markets. Product
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extension mergers join companies that produce similar products to develop a product
line. Conglomerate mergers involve companies that are producing entirely different
products.
Monopoly: A single seller in a well defined market which faces no close substitutes.
Mutual forbearance: When firms refuse to compete aggressively because they face
retaliation in the many markets where they compete.
Non-price competition: Attracting customers through means other than pricing such as
quality enhancement, servicing, advertising, delivery, and other ways to stimulate sales.
Oligopoly: A market with many buyers and a few interdependent sellers.
Predatory pricing: The attempt by a firm to lower prices far enough to eliminate a rival
in the market, with the intention of recouping profits in the long run.
Price war: Retaliatory pricing that forces market prices down until firms exit from the
market.
Price leadership: Oligopolistic pricing behavior in which firms follow the price signals
of a single firm.
Product differentiation: The buyers' perception that two goods are different.
Sensitivity analysis: Examination of the effect of changing one independent variable
while holding all other independent variables constant.
Tacit collusion: A pattern of market actions and responses of oligopolistic firms that
transmit information which allow firms to set price or output without consulting each
other directly.
Technical Efficiency: A cost effective choice that allows a firm to achieve the lowest
cost for producing a given rate of output.
Vertical integration: A firm's entry into customers' or suppliers' businesses. Entry can
be accomplished through purchase of an existing firm, a vertical merger, or can be
accomplished by starting from scratch. Integration into the buyers' market is called
forward vertical integration; integration into the suppliers' market, backward vertical
integration.
X-inefficiency: The failure to hold costs to a technically efficient (cost effective) level.
copyright
i.
Gary Jacobson and John Hillkirk.
XEROX: AMERICAN SAMURAI (New York: MacMillan, 1986)
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p. 16
ii.
Jacobson & Hillkirk, op. cit, p. 16-17
iii.
iv.
Jacobson & Hillkirk, op. cit, p. 16-17
Jacobson & Hillkirk, op. cit., p. 21
v. For an excellent analysis of the relationship of monopoly and information asymmetry
see Tibor Scitovsky. "The Benefits of Asymmetric Markets" in The Journal of Economic
Perspectives (Winter 1990, V4 #1) pp. 135-148
vi.
F.M. Scherer and David Ross. Industrial Market Structure and Economic Performance.
3rd ed. Houghton Mifflin Co., Boston: 1990 Chapters 2 and pp. 439-447
vii. See Scherer, op. cit. (pp. 661-667) for a comprehensive summary of the literature.
As an example of empirical estimation see Micha Gisser.
"Price Leadership and Welfare
Losses in U.S. Manufacturing." in American Economic Review, Vol. 76 #4, (Sep. 1986) pp.
756-767
viii.
Jacobson & Hillkirk, op. cit. p.136
ix.
It is instructive to see how something as intangible as mutual forbearance can be
measured.
See for example, Robert M. Feinberg. "Sales-at-Risk"" A Test of the Mutual
Forbrearance Theory of Conglomerate Behavior" in Journal of Business, Vol. 58, no. 2
(1985) pp. 225-241
x. A good example of the way to measure such behavior can be found in: Robert T. Masson
& Joseph Shaanan. "Excess Capacity and Limit Pricing: An Empirical Test" in Economica
(August, 1986) pp.365-378
xi.
A clear, early presentation of the contestability concept can be found in William
Baumol. "Contestable Markets: An Uprising in the Theory of Industry Structure" in
American Economic Review, Vol. 72 #1, (March, 1982) pp. 1-15. To see a readable example
of the way this concept is used for policy purposes, see Steven A. Morrison and Clifford
Winston. "Empirical Implications and Tests of the Contestability Hypothesis" in Journal
of Law and Economics, Vol. XXX (April 1987) pp. 53-66
xii.
Hillkirk and Jacobson, op. cit., pp. 38-39
xiii.
Jacobson & Hillkirk, op. cit., p.286
xiv.
Jacobson & Hillkirk, op. cit. pp.69-70
xv.
Jacobson & Hillkirk, op. cit., p. 320
xvi.
xvii.
"When is an IBM Copier not an IBM Copier?" (Business Week Sep. 1, 1986 p. 68)
Jacobson & Hillkirk, op. cit., p.15
xviii.
Kurt Eichenwald "Copier Line Introduced by Xerox" The New York Times (May 4,
1988) p. 36
46