Topic 1: Market Structure, Firm Behavior and Role of Government
Textbook Reading: Chapters 1, 9
LECTURE NOTES
1. Introduction:
This purpose of this course is to provide students with an applied approach to analyzing the behavior of firms within markets. Specifically:
What are the factors that affect market structure
What are the specific strategies that firms develop in order to be successful within that market structure
How does the behavior of firms influence the market structure and market power and
The role of government in affecting the market outcome and firm strategies
As such the course seems very similar to a traditional course in Industrial Organization (IO). Indeed the textbook we are using is one of the standard textbook used in IO andthe structure of the course will follow a microeconomics/IO structure. However, our approach will be much more applied than in a traditional course. We will rely on real world case studies and data/information in order to analyze and interpret many of the strategies and outcomes that are usually addressed in a more theoretical way in IO courses. Lecture notes will contain some review of micro/IO concepts required for our analysis.
2. Measures of market concentration
Before even starting to measure concentrationadequately, we need to define the market both in terms of the product and the geographical area. That is not always easy to do. Or rather, there is often disagreement as to what the relevant product and geographical markets are. The more widely they are defined, the lower the measurement of concentration.
Class discussion: For example, is the product market for Coca Cola the market for sweet carbonated beverages or does it also include other soft drinks and juices such as Gatorade and Snapple? Is the market the US or is it worldwide?
1. Concentration ratios = sum of market shares of the four (C4) or five(C5) largest firms in the market.
2. Herfindahl-Hirschman Index (HHI) = sum of the squares of the market shares of all the firms in the market.
HHI =
This measure weighs more heavily the market shares of the firms with higher concentration. As we will see in the antitrust section of this course, it is generally used to assess the effect of mergers on the degree of market concentration.
3. Lerner Index (LI): (P – MC)/P
The Lerner Index is not a direct measure of concentration but rather of measure of market powerthat is a firm’s ability to price above cost. Specifically, it measures the price-cost margin, i.e. the degree to which the price charged exceeds the competitive price which is marginal cost.
The Lerner Index ranges from 0 to 1.
For a firm in a perfectly competitive market the Lerner Index = 0 because P = MC.
The closer the Lerner Index is to 1, the higher the price-cost margin.
Example: LI = 0.5 (P – MC)/P = 0.5 0.5P = P – MC 0.5P = MC P = MC/0.5 P = 2MC
For a firm in a monopoly market, the Lerner Index = - 1/e where e is the elasticity of demand in that market (with its sign). That is, the monopolist maximizes profit by choosing P such that:(P – MC)/P = -1/e
Note:This is simply another way of writing the profit-maximizing pricing decision for the monopolist, given its costs and market demand which can be described by the elasticity of demand along the demand curve[1].
Written in this form it indicates that the monopolist’s profit maximizing price cost margin will be lower the higher the elasticity of demand in the market. A higher elasticity of demand means that consumers will not continue to purchase the good at the same rateas the price rises. They will purchase substitutes instead or simply consume less of the good. This reduces the monopolist’s market power to raise price above the competitive level.
Class discussion:
- How does this affect the monopolist’s strategy? Prefers markets with less elastic demand because the price-cost margin (and therefore overall profits) will be greater. Will try to avoid entering markets with very elastic demand. Will invest in/consider marketing/advertising strategies and strategic behavior to decrease the elasticity of demand in the market.
- Info provided by Lerner Index vs. concentration measures
- Is low/high concentration “good” or “bad”? For whom?
3. Empirical data: Concentration Ratios, HHIs and Lerner Indices for Select Industries
Change in US Market Concentration 1997 to 2012 by Industry
Note: Netmarket.com share shows somewhat different stats as of Jan 2018:
Google: 74.52%
Baidu: 10.49%
Bing: 7.98%
Yahoo: 5.41%
Yandex: 0.79%
Lerner Index and Markups in Select US industries
Banking Sector: Lerner Index measurements in the banking industry vary quite significantly by country:
US:0.26
China: 0.26
EU: 0.30
Japan: 0.39
Russia: 0.47
Class discussion:
- Does higher market concentration explain higher Lerner Indices (price/cost margins) in banking?
- Other factors?
Concentration ratios for 5 largest banks:
US:46.53%
China: 52.52%
EU:89.67%
Japan:62.00%
Russia: 53.26%
Note: C5 is measured as: assets of five largest banks as a share of total commercial banking assets. Total assets include total earning assets, cash and due from banks, foreclosed real estate, fixed assets, goodwill, other intangibles, current tax assets, deferred tax, discontinued operations and other assets. Data is as of 2015 except 2013 for EU.
Sample Problems
1.
C5 = 16.20 + 15 + 13.40+ 11.40 + 10.20 = 66.2%
HHI = 16.22 + 152 + 13.402 + 11.402+ 10.202 + 9.902 + 7.402 + 5.502+ 32 + 2.302 + 2.502 = 1,104.56
Now assume that Tesco merges with BP obtaining a joint market share of 31.2%. The new measures of concentration are as follows:
C5 = 31.2 + 13.40 + 11.40 + 10.20 + 9.90 = 76.1%
HHI = 31.22 + 13.402 + 11.402+ 10.202 + 9.902 + 7.402 + 5.502+ 32 + 2.302 + 2.502 = 1,590.56
As a result of the merger, C5 increases by 15%while HHI increases by 36%.
Thus, HHI is a better measure of the effect of a merger on market concentration. We will discuss this in more depth when we study antitrust later in the course.
2. Using the Lerner Index to estimate the monopolist’s profit maximizing price:
Supposethe monopolist operates in a market where elasticity of demand e = -2
Recall that the monopolist maximizes profit by choosing P such that:
(P-MC)/P = -1/e
(P-MC)/P = -1/-2 = 1 /2
2(P-MC) = P
2P-2mc = P
P=2MC (a substantial difference between price and MC.)
Now, suppose the monopolist operates in a market with much higher elasticity e = -100
(P-MC)/P = -1/e
(P-MC)/P =-1/-100 = 1 /100
100(P-MC) = P
100p -100MC = P
99P = 100MC
P=100/99MC
P=1.01MC (a very small difference between price and MC.)
[1] Derivation of the Lerner index: (optional) The monopolist maximizes revenues by choosing q s.t. MR = MC, given his/her costs and knowledge re. market demand curve.
Revenue = p(q) * q (where p(q) is inverse demand)
MR = dRevenue/dq = p(q) *1 + dp(q)/dq *q = p+dp/dq * q = p(1+dp/dq*q/p)
Elasticity of demand = dq/dp*p/q
So, MR can be expressed as p(1+1/e) and MR = MC can be expressed as p(1+1/e) = MC or:
1+1/e = MC/p
1/e = MC/p – 1
1/e = (MC-p)/p or (p-mc)/p = -1/e