Markets and Market Structure: The Structure-ConductPerformance Paradigm (I. Bobel 2011)
Economists use the abstract notion of a “market” to describe how
individuals (such as buyers and sellers or firms) but also groups
of firms (industries – the microeconomic dimension) and groups of
people (even nations as a whole – the macroeconomic
dimension) interact and trade with each other. Typically a market
consists of (at least) two parties who are involved in such a
mutually beneficial interdependent activity: a seller and a buyer.
There is a market for nearly everything in the economy! When
dealing with markets, textbook- economics concentrates on the
following three types of markets: the goods market (where goods
and services are traded), the input or factor market (where factors
of production – like land labor or capital – are bought and sold),
and the market for foreign trade (where domestically produced
goods are exported and foreign produced goods are imported).
The ultimate outcome of each of these different market
transactions is always determined at such a point where buyers
and sellers come to a final agreement and close the deal. We call
this the “market equilibrium” which is characterized by an
“equilibrium price” and the “equilibrium quantity” of the respective
good or service traded. Depending on the market under
consideration the price carries a different name: on the goods
market it is called “the goods price”, on the labor market the
resulting price is “the wage”, on the capital market it is “the
interest rate”, and on the market for foreign trade it is “the
exchange rate”.
From a microeconomic, managerial perspective it is important to
note that markets and industries can be distinguished according
to the degree of market power that each individual participant
involved in the market transaction possesses. At the same time
this indicates how competitive the overall market or industry
ultimately is. Market power is defined as the ability of any market
participant to actively influence the market price. In fact, this is –
besides many other features that can be listed to distinguish
market structures – the single most important criterion. An
incomplete list of criteria (because there are too many) to
distinguish market structures would include: the number of firms
in the market; the degree of product differentiation; the degree of
market churn (turnover of customers); the concentration ratio
(size of market share); the nature of costs (are sunk costs
important?); the degree of vertical integration, barriers to entry,
and many more. The spectrum of market structures runs between
two extremes (which we shall analyze in detail in Units 6 and 7):
at the one end of the spectrum we find firms that have no market
power whatsoever and who produce homogeneous products
(such as agricultural products like milk or grain). Such a scenario
where many totally powerless firms and many buyers are
dominating the market is called “perfect competition”. All firms
take the market price as being given – they are price takers and
face a horizontal market demand curve. The opposite extreme
case is is a case of “imperfect competition” and is called “pure
monopoly” where only one single firm dominates the entire
market - it can set the market price and faces a (downward
sloping) market demand curve for a differentiated product that it
offers. Such a firm is obviously a price maker. Both extreme
cases (perfect competition and pure monopoly) rest on extreme
assumptions and rarely show up in reality. However, they are
widely used as benchmarks (for ex. by antitrust authorities)
against which real-life cases are tested to prove anti-competitive
behavior exerted by firms on specific markets (now relax for a
minute and listen to Tim Wu (2011)– he talks about the
development of market dominance and the rise of information
monopolies). More realistic practically relevant cases of market
structures, the cases of oligopoly and monopolistic competition,
are mixtures of these two extreme cases. Oligopolistic firms can
be found in markets that are dominated by a few large companies
that possess market power, sell some branded product - but are
mutually interdependent when developing their individual
business strategies. Such firms have to take into account the
likely reactions and conduct on any price or non-price competitive
actions that they perform. The digital media player industry or the
soft drink industry (where few giant firms dominate), the market
for sports footwear or crude oil and the refining of petroleum
products are examples. Finally, the most frequently found market
structure is the case of monopolistic competition where many
(smaller) firms are selling slightly differentiated goods so that they
have at least some degree of market power. The market is easy
to enter and can be highly competitive (as it is in the cases of
small restaurants located in city centers, coffee bars, drug
retailing or pizza delivery services).
Typically individual firms are assumed to follow the goal of profit
maximization, that is, making the difference between revenues
(price times quantity) and costs as large as possible. There is an
important conceptual tool to analyze differences in the degree of
competitiveness among companies and industries which dates
back to the classic, standard Industrial Organization (IO)approach in the Bain-Scherer tradition (Scherer and Ross, 1990).
This approach embraces firms, industries and the economy as a
whole as it applies the so called “Structure – Conduct Performance Paradigm” (SCP Paradigm) as a theoretical tool
whereby the terms “market” and “industry” are used interchangeably. “This paradigm was originally developed to help
governments identify industries within which social-welfaremaximizing perfect competition dynamics were not unfolding”
(Barney 2002, p. 54). The graphical scheme below is selfexplaining and describes the conceptual framework (the following
discussion draws on Scherer 1996, pp. 2-5).
The structure of an industry determines the conduct of buyers and
sellers and, by implication, its performance along such
dimensions as profitability, efficiency and innovativeness
(Ghemawat 1997). Market Structure (especially the number of
competitors and the degree of rivalry between the competitors) is
the principal influence on a company’s behavior (Market Conduct)
whereby market structure itself depends on the external
conditions of supply and demand and results in the attempt of
firms to influence the Intensity of Competition. At the same time
Public Policy might have a direct impact on both Market Conduct
and Market Structure. An example might be public utilities
competing with private sector firms. Incentive systems (like taxes
and subsidies) are frequently tailored to the conditions of
individual industries. A company’s conduct will be influenced by
the way how government regulates a market (for example,
through price controls or other interventions).
The final outcome (Performance) centers around the “big trade
off” between equity and efficiency. “Good performance is what a
nation’s citizens ultimately seek from their industries” Scherer
1996, p. 3) There is an obvious feedback-effect (as shown by the
dotted lines in the graph below) incorporated in this process as
Market Conduct, for ex., will also impact the Basic Conditions
while the Market Structure will, in turn, shape the Basic
Conditions of Supply and Demand. This implies that the chain of
causation does not run in only one direction. Pricing and product
strategies can have an impact on the structure of the market,
while legal tactics (like lobbying) can have an impact on public
policies or on entry into the market.
Bain and Scherer advanced the research program of uncovering
general relationships between industry structure and performance
through an extensive set of empirical studies for the US. The
same was done in Europe by Manfred Neumann, Ingo Bobel and
Alfred Haid (1982; 1983) who published a number of empirical
studies on the question why some industries were more profitable
than others.