FUNDAMENTAL THEORY OF INDUSTRIAL ORGANISATION

STRUCTURE – CONDUCT –PERORMANCE The S - C- P paradigm was the dominant paradigm in industrial organization from 1950, is even today the basic framework for studies on market power - profitability relationship. It argues that the performance of an industry or firm is determined by the behaviour (conduct ) of buyers and sellers, which in turn is determined by structural attributes of the market in which it operates. Structure: Structure refers to the character and composition of the markets and industries. It describes the environment within which firms in a particular market operate Structure refers to the number and size distribution of the firms in an industry. The main structural characteristics are :

Number and size distribution of the firms. Degree of product differentiation Condition of entry / exit The extent to which firms are integrated or diversified.

Number and size distribution of the firm: Number of firms gains significance because of the notion that the fewer the number of firms in the market, the more likely is the firm to perform like a monopolist. For example, under perfect competition , s firm which is one among many, sells the product at a market price that is equal to marginal cost. From the society’s point of view a competitive firm’s outcome is efficient and hence perfect competition is an efficient market structure. In contrast the equilibrium outcome is inefficient with price > MC. Fewer the number of sellers, the more likely is the market to perform like a monopolist and produce inefficient outcome.The size distribution of the firm is also a significant factor because a market with one large firm and several small firms is likely to perform like a monopolist than a market with few firms of roughly equal size.Number and size distribution of buyers affects conduct and performance. Fewer the buyers greater will be their bargaining strength and buyers will gain monopsony power which will affect efficient outcome. Product Differentiation: Differentiated products give monopoly power to the seller. In markets with product differentiation, P > MC and hence market outcome is inefficient. Product variety increases monopoly power of the firm.Entry conditions: Entry conditions affect number and size distribution of the firms and thus influence the performance of the firms in the market.Conduct refers to the behavior of firms in a market. It explains the decisions firms make and the way in which these decisions are taken. It focuses on how firms set prices, whether independently or in collusion with others in the market, how firms decide on their advertisement and research budgets and how much expenditure is devoted for these activities. Performance: Performance refers to productive and allocative efficiency of the firms and social welfare. The essential question is whether or not firm’s operations enhance economic welfare. Productive efficiency requires avoiding wasteful use of resources and allocative efficiency is producing the right good in right quantities. Perfect competition

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is a market structure that guarantees both productive and allocative efficiency. Under perfect competition, when the firms are in long run equilibrium, P = MC and LAC is at its minimum thus assuring both allocative and productive efficiency. Under imperfect competition, when firm is in equilibrium, P > MC and inevitably there is excess capacity since the demand curve is downward sloping due to monopoly power of the firms. Hence any market that is imperfectly competitive is characterised by allocative and productive inefficiency.The SCP Paradigm

The S – C- P paradigm was based on the following hypotheses: i) Structure influences Conduct:Lower concentration → more competitive the behavior of firms.ii) Conduct influences Performance.More competitive behavior → less market power (i.e., greater social efficiency).iii) Structure influences Performance: Lower concentration leads to lower market power. As number of firms increase (i.e., market concentration falls), market power declines (i.e., price gets closer to marginal cost). ( i),( ii) and ( iii) imply that directly and indirectly, structure determines

performance.

STRUCTURE -- CONDUCT - PERFORMANCE

Empirically, when comparing industries, we observe that industries with lower concentration have less of market power..

The basic tenet of the S-C-P paradigm is that the economic performance of an industry is a function of the conduct of buyers and sellers which, in turn, is a function of the industry's structure. Economic performance is measured in terms of welfare maximization (resources employed where they yield the highest valued output). Conduct refers to the activities of the industry's buyers and sellers. Sellers' activities include installation and utilization of capacity, promotional and pricing policies, research and development, and inter firm competition or cooperation. Industry structure (the determinant of conduct) includes such variables as the number and size of buyers and sellers, technology, the degree of product differentiation, the extent of vertical integration, and the level of barriers to entry.

The relationship between industry structure and performance in this paradigm is derived from the perfectly competitive market model. Because this is a static model, competition is viewed in terms of the equilibrium condition. In the long run equilibrium, perfectly competitive markets will result in the optimal (welfare maximizing) allocation of resources in an economy. Under conditions of perfect competition , and in the absence of public goods and externalities, economic welfare would be maximized when the Pareto marginal conditions of welfare are fulfilled. The three marginal conditions are :Efficiency in Consumption : MRS

XY for A = MRS XY for B

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Efficiency in Production : MRTS LK in the production of X = MRTS LK in Y Efficiency in product mix : MRPT XY = MRS XY

The essence of these conditions is that price should be equal to Marginal Cost ( P = MC). This condition is satisfied only under perfect competition. In the long run under perfect competition MR = MC = Ar ( P ) = LAC ( min ). The equality of price to MC ensures allocative efficiency; while LAC being at minimum at equilibrium ensures productive efficiency. All other allocations of resources are judged relative to the allocation that is obtained under perfect. competition.

Under imperfect competition the AR curve and MR curve are downward sloping and hence at equilibrium, when MR = MC, Price ( AR ) is greater than Marginal Cost ( AR ( P ) > MC ) This is sown in the following figure.

In the figure , due to the monopoly power of the imperfectly competitive firm, the firm’s AR curve and MR curve are downward sloping. An imperfectly competitive firm derives its monopoly power from restricted entry that puts a limit on the number of

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sellers and product differentiation. The firm’s equilibrium is at e, at which MC = MR. However, corresponding to equilibrium, LAC is still falling and not at minimum point.

This shows that there is excess capacity to the extent of M Xc. This excess capacity is termed as production inefficiency. The equilibrium price OP = RM is greater than marginal cost, eM by eR. Thus there is allocative inefficiency also. Hence it is inferred that under imperfect competition, firms enjoy monopoly power due to features such as few selles, high entry barriers, differentiated products etc, which result in inefficent outcomes.

As indicated earlier, an industry's structure includes several important elements. Some of these elements, including buyer and/or seller concentration, product differentiation, and the elasticity of demand for the product have obvious effects on structure. Another element of structure is barriers to entry,. The concept of entry barriers in the S-C-P paradigm was popularized by Bain who defined entry barriers as:

"the advantage of established sellers in an industry over potential entrant sellers, these advantages being reflected in the extent to which established sellers can persistently raise their prices above a competitive level without attracting new firms to enter the industry" (Bain, 1956:3) Such barriers as: economies of scale, absolute cost advantages (independent of scale), product differentiation, and capital requirements (Bain, 1956).

The S C P paradigm was popularised by Joe Bain ( !949, 1950, 1951). Bain argued that barriers to entry and market concentration ( number and size distribution of firms), are essential to the relationships between industry structure and performance. Barriers to entry involve economies of scale, entry capital requirements s and product differentiation that separate the established firms in the market from the potential entrants. Firms operating in the market that is costly to enter will reap high profits without attracting entry as compared to the market with low entry costs ( barriers). Moreover high level of concentration makes leading firms aware of their market power and inter dependence which intensifies the possibility of collusive pricing.

Entry barriers are essential to the link between industry structure and performance; in the absence of entry barriers, above normal (monopoly) profits can not exist in long run equilibrium. All such profits are eliminated by the entry of new firms as the industry moves toward long run equilibrium. Because entry barriers must be present in an industry for above normal profits to persist, structure determines potential performance. Of course, appropriate conduct is necessary to realize the potential.

The S-C-P paradigm implies that the structural characteristics of an industry, particularly the level of concentration of firms and the height of entry barriers, have a significant influence on the ability of firms within an industry to price above the competitive price. Consequently, these structural characteristics can be expected to determine the performance potential of individual firms.While cost advantages, economies of scale, product differentiation and initial high capital requirements are strong barriers to entry , there are also proxies for entry barriers.

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Minimum efficient scale is a possible proxy that can be used to capture scale economies in a market.

In the figure drawn, Xmes is the minimum efficient scale.Minimum efficient scale is the size of the firm at which long run average cost curve is at its minimum and can be measured as the average size of the assets of the firms that account for 50% of the industry turnover. Capital assets ratio measured as assets to sales ratio is another proxy for barrier. High industry capital intensity gives evidence of large sunk costs which yields monopoly profits to incumbent firms thus deterring new firms from entering the industry.At firm level, market share and concentration are strong determinants of profitability(performance ). Studies show a negative relationship between very high market share and profitability ( indicator of performance), due to X inefficiency. X inefficiency is defined as the ability of a firm to maximise the value of outputs from a given set of inputs. It mainly occurs due to the misalignment of manager’s personal growth with the goals of the owners. For example, manager’s objective such as empire building, excessive remuneration and aversion to risk result in sub optimal use of resources. In competitive markets with small profit margins, the disincentives for X inefficiencies are strong since even a small decrease in cost will result in substantial increase in profits. Inefficient firms can not survive competitive pressure. X inefficiency is strongly related to market power since it is mostly observed in monopolies and oligopolies. Concentration affects profitability via market share, leading to higher profitability of firms in highly concentrated industries.

Under perfect competition and monopoly the performance can be predicted from structural features of the market. The features of large number of buyers, homogeneous products and free entry and exit conditions imply efficient outcome of P = MC and Least cost production at equilibrium. Similarly, single seller, closed entry conditions, and absence of good substitutes imply inefficient outcome. Structural features give sufficient information to predict the performance. However it is not always possible to predict the performance of the firm from structural characteristics. In the case of Oligopoly, one can not predict the performance from structural features. The firms under Oligopoly may react in a collusive or non collusive manner ; that is there may be

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collusive or non collusive price war or output war . Bypassing the conduct may lead to misleading inferences. In the traditional approach of S –C- P paradigm, structure is determined exogenously which has been criticised by many. Market structure is determined by performance and conduct. This rules out the linear relationship between structure, conduct and performance. Instead the S C P relationship is circular as given below.

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3. STRUCTUREEconomic theory suggests that structural features of an industry influence the behaviour of firms that is, the price, costs, and innovative activity of the firms. The market structure gains importance from the hypothesis that the performance of a market is influenced by the decisions taken by the firms in the market (conduct) and that these decisions reflect the amount of autonomy firms have in terms of competitive environment in which they make decisions. This environment is the market structure and this hypothesis is the S- C P paradigm. The S-C-P paradigm identifies structure as those elements over which the firm has little control , that is , which provide constraints on its decisions. It suggests that structural features are the most important of determinants of industrial performance. However it is important to recognise that structure of individual industries is not fixed and exogenous but is changing and endogenous. Some of the factors which influence structure are aspects of conduct and performance of the firms in the industry. For example, firms may create barriers to entry by engaging in advertising.

The various dimensions market structure are: 1. Seller concentration2. Barriers to entry3. Product differentiation4. Vertical integration5. Growth and elasticity of demand6. Buyer concentration7. Foreign competition1. SELLER CONCENTRATION: Seller or market concentration refers to the extent to which production in a particular market is controlled by few firms. This is determined by the number and size distribution of sellers. Buyer concentration is similarly defined by the number and size distribution of buyers operating in a particular market. Seller concentration is a significant dimension of market structure because of its influence on conduct and performance of the firms.

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The most widely used measure of concentration is the concentration ratio, which measures the shares of the top ‘n’ firms and is expressed as :

CRi = Pi

where Pi is the market share of the ith firm. All the firms included in the measure are treated equally. In other words, they are al given a weight of one. The choice of one is arbitrary and in fact is dictated by information available in the census of production. The concentration ratio obviously gives only very limited information on the number and size distribution of the firm.

The concentration measure CRi is simply the sum of the market share of the ‘i’ largest firms in the market , where ‘i’ is a small number. Thus if i = 5, then CR5 = 90, means that five largest firms in the market control 90% of the industry size. The five firm concentration ratio CR5 is commonly used in UK while CR3 or CR4 are more common in USA and other countries. Yet another measure of market concentration is the Herfindahl index. The Herfindahl index takes account of all the firms in an industry. It can be defined as :

H = Pi2

Where Pi is the share of the ith firm and ‘n’ is the number of firms in the industry. The maximum value of the index equals 1 and occurs where there is only one firm. The minimum value, when firms are of equal size, depends on the number of firms and is the reciprocal of ‘n’. Thus when n = 100, the minimum value of the index is 0.01. The squaring of the index means that smaller firms contribute less than proportionately to the value of the index. The various indices of concentration available such as CR, and HI are all concerned with absolute inequality and the most fundamental differences among them is with reference to the weight they assign to the market share of the firms. Other indices have been divised emphasising relative inequality. Relative inequality measures of concentration focus on the degree of size in equality rather than on number of firms operating in a market. They are summary indices and their graphical representation is called as the “Lorenze Curve”. A Lorenze curve relates the cumulative percentage of market output or size ) to the cumulative percentage of firms starting from the smallest Seller concentration has important implications for the behaviour of the firms in both differentiated and homogeneous product markets for several reasons:

The cost of search and acquisition of information by consumers may depend crucially on the number of firms operating in a market. When sellers are known to charge different prices for the same (or similar) product, consumes would benefit by the acquisition of relevant information, which can be obtained by visiting or contacting the firms prior to purchasing. Getting such information however involves cost. While several factors may contribute to search costs, the number of firms in the market is very significant. The fewer the firms, the easier it is for the consumers to acquire information and therefore the more difficult it is for sellers to maintain price differentials. Factors affecting the cost of time, such as occupation, age, income level vary among markets with the same

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number of firms. Similarly, factors which facilitate the flow of information such as the localisation of markets or improvements in information technology make consumer search easier which tend to reduce price differentials.

Seller concentration can influence oligopolistic interdependence and price- cost margins. When a few firms produce a homogeneous product, which is sold at a uniform price, if one seller were to increase his output, the market price and the revenues of all other firms would fall, thus inducing them to consider an appropriate response. The effect on market price and competitor’s revenue will depend on the number of firms and their relative size. Thus a 20%expansion in output by a firm controlling, say, just 10% of the market is unlikely to have a significant impact on prices and market share while the 20% expansion by a firm controlling 50% of the market will have a significantly large impact and trigger fierce competitive reactions. In short the extent of interdependence depends on both the number and size distribution of the firms in the market.

Concentration may considerably influence inter firm knowledge. Information about rival’s behaviour regarding price policies, advertising budgets, expenditure on research and development or product investment decision is not usually easily available. As a rule the cost of search and collection of information increases with the number of firms producing the same or a strongly similar product. This is particularly true when firms are of equal size, when substantial differences in firm size exist, it may be only necessary to consider the behaviour of the dominant firm.

As the number of firms declines, a firm’s own sales figure becomes a good source of information about the rival’s behaviour. This is because, given the general market conditions a loss in sales or market share might be due to a successful change in the rival’s behaviour. Indeed the higher the concentration the smaller the probability of random sales fluctuations and the easier it becomes to detect secret price cuts. Thus a higher degree of concentration not only contributes to a strengthening of oligopolistic inter dependence, it also facilitates co- operation by making easier, the detection of cheating. Higher the level of concentration in a market, the less competitively the firms are likely to behave , with consequent effect on performance. Concentration also plays an important role in merger and monopoly policy. For instance in U K a monopoly situation is defined in law with reference to simply a market share criterion : a monopoly exists if one firm accounts for 25% or more of the sales of a product. In the USA also restrictions have been placed on both horizontal and vertical mergers through reference to market concentration levels.BARRIERS TO ENTRY : An important aspect of market structure is the height of the entry barrier that new firms have to face if they wish to enter an industry. Entry conditions determine the extent to which existing firms can pursue monopoly behaviour without inducing a response from potential competitors.The theory of entry barrier originates from the work of Joe Bain. He suggested that when entry into a market is possible , firms may choose to charge a price lower than the full monopoly price in order to discourage or prevent entry so as to maximize their profits in the long run.

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Bain defined entry as the extent to which established firms can persistently raise their price above competitive level without attracting new firms in to the industry. Barriers are therefore anything that allows a high price to prevail in the long run. Bain defined the height of the barrier or the condition of entry as the percentage mark up of maximum entry forestalling price over the minimum average cost of the established firms, that is,

Or , in terms of competitive price ,

The barriers to entry refer to the cost advantages of the established firms over the potential entrants or product differentiation which enhances consumer choice . Hence barriers need not necessarily have adverse welfare effects. Bain distinguishes four main barriers to entry.

Product differentiation or preference barrier Absolute cost advantage of the established firm Economies of scale Large initial capital requirement.

Product differentiation barrier: The product differentiation barrier gives the firm a degree of control on its price. It refers to the extent to which consumers perceive products to be different. Product differentiation can have a significant influence on consumer preference which in turn influences the shape and position of the firm’s demand curve. This affects distribution of market shares and degree of market concentration. Product differentiation creates brand loyalty to products for which firm incurs heavy expenditure on R & D and advertisements. Newly entering firms will have to spend heavily to break existing consumer preferences and brand loyalty. This will reduce their profit and hence deter entry. A second possible entry barrier is economies of scale. If the minimum efficient size of the firm is large in relation to the size of the market, if there is substantial cost disadvantage in operating at a sub optimal size, there will be a sizable obstacle to the entry of new firm. When MES occurs at large output level, new entrant firm must be at a large scale if the potential entrant is to achieve the same per unit cost as the existing firm. But given the market size this increase in output will reduce market price. If price falls below average cost (P< MC) the prospects for losses will discourage new entrants. The strength of this barrier depends on the size of the MES in relation to market and on the price elasticity of demand.A third possible barrier exists in the form of absolute cost advantage that the existing firms will have over entrants. This cost advantage to existing firms may arise from:

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Possession and control by established firms of exceptionally skilled management team or other scarce resources.

Possession of superior techniques, and know how, possibly protected by patents. Control of supply of raw materials. Cost of capital may be low for existing firms. Production costs of established firms may be lower than that of entrants because

of vertical integration.A fourth possible barrier to entry arises due to the existence of imperfect capital market because the initial capital requirement of potential entrant may be heavy which may be difficult to raise for the entrant. Besides these, institutional barriers like patent legislation, which provides a firm exclusive rights to manufacture a specific product or to use a specific process , can also discourage entry. As a result of all these factors that strengthen barriers to entry, new firms may not enter an industry easily, which makes the structure concentrated by new firms.VERTICAL INTEGRATION: Vertical integration refers to a situation in which two companies, who are not producing the same product but who are at different stages of the same production process, come together. If paper maker A buys saw mill company C, they are both in the same industry , but at different stages of production. This is vertical integration - more specifically backward integration because the paper mill has taken over the saw mill company which is in an earlier stage of production process.There can also be forward vertical integration when a company chooses to integrate with another company that is closer to the market. If paper maker A integrates with retailer D it is forward integration.Vertical integration confers market power on a firm over and above the level that the firm’s sales in the market would suggest. If the integration had been brought about by efficiency conditions, then the integrated firm would have competitive advantage over the non integrated firms - thus allowing it to under cut its rivals or earn higher profits at the same price. The advantage is higher if the integrated firm is larger than rivals. Vertical integration will act as a barrier to entry. If one of the firms in the industry owns a major input supply or a significant number of sales outlets, then it may become more difficult for new firms to enter the market. The integrated firm refuse to supply to new firms with the necessary inputs or may supply at unfavourable terms. Therefore the new firm will have to enter with its own source of supply for which it will need more capital and hence entry becomes more difficult.DIVERSIFICATION: Diversification is similar to vertical integration – a diversified firm has activities outside the market under consideration which will confer cost advantages. Also a diversified firm will may be able to compete more fiercely in one of its market than a specialist firm can, since any losses caused in any one market can be made good by the profits in another market. This advantage of diversification acts as an entry barrier and influences structure.GROWTH AND ELASTICITY OF DEMAND: Market growth influences entry - entry is much more attractive in growing markets than in markets which are stagnant and declining. Elasticity of demand influences structure by determining the extent to which firms can increase the price over competitive price. In a market with relatively more inelastic demand price can be set at a higher level than in a market with elastic demand. This will affect entry and market structure.

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BUYER CONCENTRATION: Number and size of consumers influences the nature of competition in a market. The firm will discriminate among buyers depending on whether it is selling to many small customers or to a few large customers. Large buyers will be able to make contacts with sellers on terms which are more favourable to the buyers than a small buyer would be able to secure. Large buyers will enjoy real and pecuniary economies by virtue of their bargaining position. The simultaneous existence of buyer concentration with seller concentration is known as “counter veiling power”.FOREIGN COMPETITION: Competition from imports has become an increasingly important aspect of market structure as trade liberalisation has lead to an expansion in foreign trade in many industrial products. Competition form imports will make existing firms more efficient , make them more competitive and influence the structure. Competition from imports is to be considered like entry by new firms.CONCLUSION: Market structure is amore complex concept than is often recognised. The complexity arises because structure is multi dimentional and not exogenous. The link between structure conduct and performance is not unidirectional but inter dependent. Hence structure is influenced by conduct of the firm and its performance as much as it influences conduct and performance.

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4. CONCENTRATION

Concentration is the most frequently used feature of the market structure , by market analysts and policy makers who are involved in making policy regarding monopoly and competition. A measure of the size of concentration is required to assess its influence on firm’s behaviour and performance. There are several measures of concentration, some attempting to measure absolute inequalities in concentration and others measure relative inequalities in concentration. The two important measures of concentration are : Concentration Ratio Measure Herfindahl IndexTHE CONCENTATION RATIO:The most widely used measure of concentration is the concentration ratio, which measures the shares of the top ‘n’ firms and is expressed as :

CRi = Pi

where Pi is the market share of the ith firm. All the firms included in the measure are treated equally. In other words, they are al given a weight of one. The choice of one is arbitrary and in fact is dictated by information available in the census of production. The concentration ratio obviously gives only very limited information on the number and size distribution of the firm.

The concentration measure CRi is simply the sum of the market share of the ‘i’ largest firms in the market , where ‘i’ is a small number. Thus if i = 5, then CR 5 = 90, means that five largest firms in the market control 90% of the industry size. The five firm concentration ratio CR5 is commonly used in UK while CR3 or CR4 are more common in USA and other countries. The CR measure provides useful information regarding the extent of market concentration at a particular point of time as well as its trend over time. The CR measure is simple in construction and interpretation.

Limitations :The limitation of CR measure is its focus on few large firms rather than on the whole industry. Suppose for example CR4 = 80, this clearly indicates that the industry described is an oligopoly in which four firms control 80% of the market. This is useful information but we can not infer from this the likely behaviour of the industry. We have no information about the relative size of the four leading firms, which can have an important influence on the way in which firms respond to each other’s action. Competitive behaviour would be different when the four firms are equal in size than when one firm controls 40% and the other three share remaining 40 %. The CR measure gives no information on the number or size distribution of the firms not included in it. Market behaviour could be very different when two rather than 20 firms account for the remaining market share not included in the CR4.

The following figure shows the concentration curves for two industries A and B. The concentration ratio shows only one point on each of these curves. It gives no information on the number and size distribution of the firms outside the ‘n’ group and no information on the size distribution of the firms inside the ‘n’ group.

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In the figure a four firm concentration ratio (CR4) shows industry A to be more concentrated than industry B, but if the eight firm concentration is used for comparison, the ranking is reversed. From the figure we can also find out the minimum number of firms that account for a specified share of the market. In A three firms account for 50% of the market while in B the number is 4. However 8 firms in B account for 80% of the market where as in A 10 firms account for 80% of the market. If the concentration curves of the firms do not intersect, the ranking of industries is unaffected by the choice of ‘n’. Care must be taken in comparing industries since the outcome of comparison based on CR may depend on how many firms are included in it. CR emphasizes on the share of the few largest firms ignoring the significance of the relative shares and any influence that the smaller firms may have on industrial behaviour.

HERFINDAHL INDEXIf firms hold unequal market shares, number of firms is not likely to capture concentration.Example:Industry I : Two firms each with 50% market share Industry II: Three firms - one with 90% and the other two with 5 % market share Obviously, industry II is more concentrated in terms of distribution of market shares, though it has more firms than Industry I.Herfindahl index of market concentration:Suppose there are n firms in an industry. For each firm i, let Xi be the output produced by firm i. Total output in the industry: X = X1 + X2 + ... + Xn

The market share of each firm C is denoted by Pi = Xi / XHerfindahl index, H = P1

2 + P 22 + ...+ P n

2

In the earlier example:

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Industry I: n = 2, P 1 = P 2 = 1 /2 , H = 1 /4 + 1/4 = 0.5Industry II: n = 3, P 1 = 0.9, P2 = P3 = 0.05, H = (0.9)2 + (0.05) 2 + (0.05) 2 = 0.815So, the Herfindahl index tells us that industry II is more concentrated. The Herfindahl index takes account of all the firms in an industry. It can be defined as :

H = Pi2

Where Pi is the share of the ith firm and ‘n’ is the number of firms in the industry. The maximum value of the index equals 1 and occurs where there is only one firm. The minimum value, when firms are of equal size, depends on the number of firms and is the reciprocal of ‘n’. Thus when n = 100, the minimum value of the index is 0.01. The squaring of the index means that smaller firms contribute less than proportionately to the value of the index. A simple example will illustrate this and also show how two industries will be ranked differently by alternative measures that use different weighting system. In the following table, in the two industries C and D, the two firm concentration ratio CR2 is 90%. The Herfindahl index is however equal to 0.42 for C and 0.66 for industry D. The concentration ratio takes no account of the relative size of the two largest firms, whereas the Herfindahl index does consider this Further more it is clear that the contribution of the firm to the overall index diminishes rapidly with size. In C, for instance, the smallest firm is 1/5 the size of the largest, but it contributes only 1/25 as much to the index.

Industry C Industry D

Market Share ( %)

Square of Market share - Pi

2

Market Share(% )

Square of Market Share - Pi

2

50 40 10

0.25 0.16 0.01

801010

0.640.010.01

100 0.42 100 0.66

The Herfindahl index satisfies all the desirable conditions for a concentration index. It takes in to account both the number of firms and size distribution of the firms in the industry. Squaring of market shares implies that smaller a firm, smaller is its contribution to the index.

LORENZ CURVE - RELATIVE MEASURE OF CONCENTRATION

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The various indices of concentration available such as CR, and HI are all concerned with absolute inequality and the most fundamental differences among them is with reference to the weight they assign to the market share of the firms. Other indices have been divised emphasising relative inequality. Relative inequality measures of concentration focus on the degree of size in equality rather than on number of firms operating in a market. They are summary indices and their graphical representation is called as the “Lorenze Curve”. A Lorenze curve relates the cumulative percentage of market output ( or size ) to the cumulative percentage of firms starting from the smallest. In the following figure a hypothetical Lorenze curve is drawn. In the figure drawn, the Lorenze curve lies below the diagonal line and is concave from below. Since equality here all the firms in the market have the same size, so that 10% of the firms account for 10% of the market size, 20% of the firms account for 20% of the market and so on, the diagonal line represents absolute equality. In a market of equally sized firms the Lorenze curve coincides with the diagonal line. Otherwise it is below it and further away from the diagonal it is, higher the extent of inequality in the market it describes. Graphically the larger the area between the two curves ( the striped area in the figure), the more significant will be the size of inequality. The shaded area is called area of inequality, An index of inequality commonly used is the Gini Coefficient. This measures the area of inequality as a % of the total area below the diagonal of the triangle OAB.

Area of inequality Gini coefficient= Area below the diagonal line

An obvious weakness of the Lorenze curve is that it ignores numbers altogether. An industry of four equally sized firms would have the same Lorenze curve as that consisting of 40 equally sized firms.

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Desirable properties of a concentration measure The desirable properties of concentration measure are :

The measure used must yield an unambiguous ranking of industries. A concentration curve that lies entirely above another represents a higher level of concentration.

The measure should be independent of the size of an industry but be a function of the combined market share of firms.

Concentration should increase if the market share of any firm is increased. If a large firm wins a customer from a small firm, concentration increases; ie, the principle f transfer must hold.

The concentration measure should be a decreasing function of the number of firms.

The limits of a concentration measure should be between zero and one. Mergers increase concentration. The entry of a new firm below some significant size reduces concentration

DETERMINANTS OF CONCENTRATIONThe various determinants of concentration are :

Economies of scale Entry barriers Mergers Government policy Technological change Vertical integration Market growth Advertising

Economies of scale : Economies of scale is a very crucial determinant of concentration. A firm enjoys both plant economies of scale as well as economies of size arising from

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multi plant operations. Some of these may be real economies while there are also pecuniary economies. On the production side the firm enjoys cost advantages arising from production technological economies such as specialization and division of labour. Besides these, the firm enjoys firm specific economies related to major functions of the firm. Such economies are managerial economies, economies of bulk ordering, economies of R& D, and financial economies. The various economies reduce the cost per unit of the firm and is responsible for the downward slope of the firm’s average cost curve. However the firm also suffers diseconomies of scale arising from increased cost of materials and transport and distribution and diseconomies from deteriorating labour relations. But these diseconomies are specific to the plant and will not affect the growth of the firm since the firm can grow by operating a large number of plants, all of optimum size. At the firm level the most prominent diseconomies are the diseconomies of management. The diseconomies will increase the cost per unit of the product for the firm and if they are stronger than economies, the average cost curve will slope upwards. The relative strength of the economies and diseconomies are responsible for the shape of the firm’s average cost curve in the long run . In the following figure economies are shown by the downward sloping portion of the LRAC, over the output range, OM. At the output level OM, Economies and diseconomies cancel out each other and Lac becomes constant thereafter. LRAC beyond OM is horizontal and parallel to X axis. OM is the minimum efficient output or scale (MES). MES is the minimum (smallest ) size of the firm that can exploit all economies of scale and thus minimize average cost in the long run.

The economies of scale and MES raise two important questions:1.How large is OM, in relation to size of the market? If it is half the market size , the market can spore only two firms of optimum size; if it is I/50 of market size, the market is large enough to support 50 firms of optimum size and so on. In the extreme case where MES represents 100% or more of market size the industry is called a natural monopoly. The higher the MES in relation to market size, higher would be concentration, ceteris paribus.2.How steep is the cost curve to the left of MES? The answer to this tells us the cost the disadvantages suffered by firms of sub optimal size, i.e, it tells us how important economies of scale are in a quantitative sense.

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Given the ‘L’ shaped LRAC, firms at or above OM output level are equally efficient. Therefore it is not appropriate to say that concentration will be at the level consistent with ‘n’ firms of optimal size, where n is equal to market size / MES. It is more realistic to assume that n / MES defines the upper limit rather than the number of firms in the industry. Another relevant issue is the slope of the average cost curve to the left of OM – steeper the curve indicates greater cost disadvantage from being sub optimal in size and makes it difficult for smaller firms to survive. Empirical research indicated that economies of scale are an important determinant of concentration in the following sense:

The higher is MES in relation to market size, the higher concentration tends to be.

Increased concentration was due to technological change which generated economies of scale (chemical, vehicle and metal industries)

Technological economies have not increased concentration in plastics and electronics.

The relationship between economies of scale and concentration may be high in a relatively small closed economy and may be low in an economy with a large domestic market or one in which international trade is important.Further the relationship between economies of scale and concentration is an equilibrium relationship which can not be expected to hold in every industry all the time.

ENTRY BARRIERS: Entry conditions determine the extent to which existing firms can pursue monopoly behaviour with out inducing a response from potential competitors. Since entry barriers slow down or prevent new entry, they may, ceteris paribus, contribute to a more concentrated market structure. When incumbent firms are protected from potential competition, they are more likely to restrict production in order to charge a price higher than the competitive price ( P > Pc ). As a result the market size declines which will increase concentration. Further more large established firms may be able to expand output at a constant cost increasing their market share at the expense of smaller firms which enhances the existing size inequalities.MERGERS: Merger activity can have significant and positive influence on concentration. It is believed that the flurry of merger activity that followed second world war is one of the most important contributory factor to increased aggregate concentration in U.KGOVERNMENT POLICY: This can take many forms. The granting of patent rights on inventions will increase concentration in some industries. As a major buyer of goods and services , governments may show a bias in favour of large firms. Government’s attitude towards monopoly merger policy will determine concentration.Technological change: Technological change has been recognized as a major influence on market structure. Many economists like Karl Marx, and John Kenneth Galbraith have argued that technological change tends to increase plant size and the level of industrial concentration. This is because the term technological change usually refers to improvements in production process which enhance economies of scale, increase Minimum Efficient Size ( MES) and the degree of concentration. Technological change can also lead to introduction of new products and major product innovations are almost

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by definition characterized by a uniqueness which is likely to give monopoly power to the producer.Vertical Integration can influence both the nature and strength of oligopolistic interdependence and the ease or difficulty with which new firms can enter the market . Thus vertical integration can be a strong influence on concentration ., through its impact on barriers to entry.Market Growth: Market size has always been recognised as a factor of concentration. Market size in relation to MES can influence the number of firms operating in the market. For a given MES, larger the market, larger the number of firms can be and smaller the market, fewer the firms. Therefore concentration will be higher. It is observed that slow growing markets tend to be monopolised easily and in general an inverse relationship exists between concentration and market growth.Advertisement is an important factor that increases market concentration, particularly in consumption goods industries. Heavy advertising may be possible only by large established firm which enjoys economies of advertising. This increases concentration by creating strong consumer preferences for the product of few large firms which advertise heavily.

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CASE STUDIES: MARKET FOR MOSQUITO REPELLER

Tortoise losing the repellent raceIn real life, slow and steady does not always win the race. Tortoise, the over 30-year old mosquito repellent brand is losing out. A look at the AC Nielsen data for the household insecticide market shows that Tortoise coil, the market leader in the ‘90s, has witnessed a dramatic fall in its market share. From a share of 32.9 per cent in 1998, the Tortoise brand has slid to 2.3 per cent in 2003. A relatively new player, Maxo coils from the stable of Jyothy Laboratories, has reached the number two slot after Reckitt Benckiser’s Mortein . From a meagre share of 0.3 per cent in 2000, Maxo’s share has been on an upward curve, topping 22 per cent in 2003. Of the Rs 835.65 crore household insecticide market, coils form 52 per cent of the pie of around Rs 439.34 crore. The coil category is spilt into two — green and red coils. Preferences are increasingly shifting towards red coils as these last longer. Godrej Sara Lee’s flagship brand Good Knight and regional brand Jet have recorded a share of 20.2 and 14.1 per cent, respectively, in 2003. Both the brands have maintained their shares of 2002. Refills, the second largest category in the household insecticide market, has a share of 19.7 per cent, accounting for about Rs 164.4 crore. All Out refills from Karamchand Industries has eaten into GoodKnight’s market share. To retain its position as market leader with a share of 63.3 per cent. GoodKnight’s share has slipped from 35.4 per cent in 2002 to 29.6 per cent in 2003. Mats form 10.9 per cent — about Rs 91.28 crore of the household insecticide market — while aerosols have a share of 6.6 per cent (about Rs 55.16 crore). In the mats category, Mortein’s share has slid to 6.4 per cent in 2003 from 7.4 per cent in 2002, while GoodKnight maintains its leadership position with a share of 58.8 per cent. In the aerosol category, Hit is the market leader with a share of 64.5 per cent in 2003.

TYRE INDUSTRY

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Major players in the tyre industry.MRF

MRF Ltd has drawn up extensive plans to guard its position as the leading tyre company in the country. R&D spend rose from Rs 7.92 crore in 1994-95 to Rs 11.45 crore in 1995-96. The company has a 28 per cent share of the overall market. It has a presence in practically every segment from tractors to animal-drawn vehicles, and from cross-plies to radial tyres. Around 60 per cent of its turnover comes from the truck and bus segment, which accounts for 75 per cent of the total tyre market. A leading original equipment manufacturer (OEM), it is the exclusive supplier to Ford, General Motors and Fiat Uno. MRLs manufacturing capacity of 91 lakh tyres per annum is spread over facilities located at Tiruvattiyur and Arkonam in Tamil Nadu, Kottayam in Kerala, Medak in Andhra Pradesh and at Goa. Now, a greenfield Rs 200 crore manufacturing unit is being set up at Pondicherry. This is the first phase of the expansion plan. The 1.5 million capacity plant will exclusively manufacture radial tyres for the truck and car segment. It is expected to commence operations by early 1998.This multi-locational capability has been MRF's greatest competitive strength. It not only ensures optimum production levels but also enables it to quickly service different markets.Apollo tyresA fast-growing Apollo Tyres is giving tyre leader MRF a run for its money. In fact, the company emerged as the market leader in the all-important truck and bus segment with a market share of over 23 per cent in 1995-96. Its share in 1994-95 was 18 per cent. Turnover in 1996-97 crossed the Rs 1,400 crore mark from Rs 1,237 crore in 1995-96. Five years ago, its turnover was Rs 190 crore. Profits fell from Rs 33 crore in 1991-92 to Rs 16 crore in 1993-94 but rose again to Rs 33 crore in 1995-96. Nevertheless, Apollo has been rated as the fastest-growing tyre company in the country, and the seventh fastest in the world by the European Rubber Journal. The company is the leasty cost producer The countrywide network of more than 1,100 exclusive Apollo tyre dealers, 2,500 main dealers and 100 marketing offices is primarily responsible for the growth. So in the light commercial vehicles (LCV) and tractor segments, market share increased from seven per cent in 1995-96 to 18 per cent in 1996-97. Apollo has tied up with Continental AG of Germany, the fourth-largest tyre company in the world, to make car radials. Also, it enhanced capacity by acquiring Kerala-based Premier Tyres with its six lakh tyres per annum plant in April 1995. Apart from increasing its presence in the domestic market, the company aims to become a global player. So exports are a thrust area. A pollo was the largest tyre exporter in 1995-96 with earnings of Rs 170 crore, up from Rs 84 crore in 1994-95. Ceat Ltd The Rs 4,769 crore group CEAT aims to touch the Rs 5,000 crore mark by 2001. As per its Vision 2001 strategy, it aims to be a market leader with a 29 per cent share. Its current market share is 17 per cent. For now, however, it is grappling with falling profits. For the 18-month period ending March 1996, net profits fell to Rs 17.72 crore from Rs 26.45 crore in September 1994.

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The thrust now is on the truck and bus segment, where Ceat has a 13 per cent market share. Ceat is also looking at joint-ventures to spur growth. Last year, it entered a 50:50 joint venture with Goodyear Tire Co, USA, to form South Asia Tyre Ltd (SATL). Ceats Aurangabad plant was transferred to SATL. Devoted to radial tyres for cars and jeeps, it has a capacity of 7.20 lakh tyres per annum. The production is equally shared by the partners. Ceat's own capacity of 50.7 lakh tyres a year is spread over its Bhandup and Nashik units. The tie-up also enables Ceat to access the latest technology. Ceat has also been focusing on brand-building. Marketing and advertisement costs went up from Rs 18 crore in 1994 to Rs 51 crore in 1996. Exports account for 12 per cent of the turnover. Ceat exports to over 30 countries. It is among the biggest cross-ply exporters to USA. In 1993, it promoted a joint venture in Sri Lanka with Associated Motorways called Associated Ceat Pvt Ltd. This has cornered 40 per cent of that market. Now Ceat is studying the Vietnam market. J K IndustriesMercedes Benz, Cielo, Maruti Zen, Tata Estate, Tata Sierra, the Armada. The list goes on. A leading original equipment manufacturer with a significant present in the passenger cars segment, JK Tyres, a division of JK Industries, has a 32 per cent share of the total radial market.JK Tyres accounts for almost 90 per cent of the over Rs 1,000 crore JK Industries group. It reported a net profit of Rs 25.58 crore in 1995-96 on a turnover of Rs 1,002 crore. The turnover witnessed a 26 per cent increase over the Rs 797 crore turnover in 1994-95. It went up in spite of the four-month labour unrest at its Jakayram plant in Rajasthan. OE sales account for 15 per cent of the turnover.But the attention is currently focused on its takeover of the joint-sector Vikrant Tyres. It will spend Rs 6.84 to acquire 90 lakh fresh shares of Vikrant Tyres at Rs 76 each. It is also acquiring 20 per cent of the expanded equity base through open market purchases. The acquisition will enable it to tap the 1.03 lakh tyres per annum capacity of Vikrant Tyres. Besides, JK plans to invest Rs 260 crore over the next few years in capacity expansion and modernisation at Vikrant Tyres. JK also has plans to augement its own capacity to 30 lakh tyres per annum in stages. So far, additional capacity of 1.65 lakh tyres per annum was added in 1995 at a cost of Rs 400 crore. The current capacity is 21.26 lakh tyres per annum.Most of the expanded capacity will be used for exports. JK was the first Indian company to export radials to Europe. Exports to over 30 countries account for nearly 17 per cent of the turnover. In fact, the exports models of the Maruti 1000, Esteem, Zen, Tata Sierra, Tata Estate and Armada are fitted with JK steel radials.Dunlop India LtdWith factories in Sahagunj in West Bengal and Ambattur in Tamil Nadu, Dunlop has one of the widest range in tyres and industrial rubber products. This includes radial tyres, aero tyres, off the road (OTR) tyres, steel-cord beltings and heavy duty hoses.To combat rising raw materials costs and dipping capacity utilisation, the management tried to streamline operations and realign the product mix. As part of a cost reduction exercise, the company consciously pulled out of high-volume segments like truck tyres, focusing instead on the industrial rubber segment, value-added aero tyres and the low-volume but high margin radial car tyres.

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The company has also been emphasising on sectors that allow a quicker turnaround of working capital like original equipment and exports. Dunlop's average exports are around Rs 40 crore per annum.Turnover for the 15-month period ending March 1996 was Rs 824.03 crore with a net profit of Rs 39 crore. It recorded remarkable results for the first half of 1996 with a sales turnover of Rs 336.37. This was a 22 per cent growth over the previous period. Also, net profits in September 1996 grew by a phenomenal 206 per cent to Rs 18.52 crore. It is believed that the lending banks have demanded an auditors' certified copy challenging the half-yearly performance in spite of the credit squeeze and downturn in the economy. And with a working capital shortage still bogging it down, it seems the company's troubles are far from over.

Goodyear India With a low installed capacity of 1.17 million tyres, Goodyear's turnover growth has been restricted in this high-volumes business. Its turnover in 1995 was Rs 495.79 crore with profits falling to Rs 5.09 crore from Rs 5.69 crore in 1994.It hopes to increase its nine per cent share in the car segment to 14 per cent in three years. In the truck and bus segment, Goodyear has a seven per cent market share, while in tractors, its share is 9.1 per cent.At Rs 268 crore, Goodyear recorded a 22 per cent growth in turnover in the first half of 1996. Profits at Rs 4.15 crore too rose by 300 per cent during the same period. The strategy now is to avail of the latest technology offered by its parent. Ever since liberalisation, the company’s strategy has been to add capacity in areas where our products will command a sizeable market share in future. These are mainly radial tyres, particularly in the passenger and LCV categories. Srichakra Tyres Continuous expansion and upgradation has been the mantra at Srichakra Tyres, part of the Rs 1,480 crore TVS group. The company is a leading player in the two- and three-wheeler tyre segment with a 28.56 per cent market share. And it is determined to further consolidate this. The future focus will also be on this segment, especially the replacement market, as well as on exports.From a start-up capacity of four lakh tyres per annum in 1984, Srichakra now has a 33 lakh tyres per annum capacity. Plans are afoot at the sole manufacturing unit in Vellaripatti village in Madurai district of Tamil Nadu to further augment this to 40 lakh tyres per annum.Turnover in 1995-96 grew by 36 per cent from Rs 76.12 crore the previous year to Rs 103.66 crore. Profit after tax rose by 90 per cent from Rs 193.34 lakh in 1994-95 to Rs 366.77 lakh in 1995-96. Around 65 per cent of the turnover comes from the original equipment (OE) segment. It is OE supplier to Bajaj Auto, Hero Honda, Escorts, Yamaha and, group company TVS Suzuki, which accounts for nine per cent of OE sales.Although Srichakra has focused on its core business, there have been some diversifications. Last year, it entered a 50:50 joint-venture with Reichle De Massari AG of Switzerland to manufacture and market electronic connectors. Then there is a 49:51 joint-venture with Dupont, entered in 1992, to manufacture and market stefflon coating and tymex bristles, and a 50:50 joint-venture with Cherry Corporation, USA, since 1993 to

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manufacture electronic switches.Srichakra also manufactures a range of industrial tyres and tubes, primarily for exports to USA and Europe. Exports turnover has grown nearly ten-fold from a mere Rs 1.24 lakh in 1991-92 to Rs 12.74 in 1995-96. Srichakra has also invested Rs 3.15 crore in setting up non-conventional energy sources for captive consumption. This investment is expected to be a hedge against any escalation in power and fuel costs. Falcon TyresDunlop's subsidiary, Falcon Tyres, based at Mysore, Karnataka, has seen a remarkable turnaround in recent years. A prominent player in the two-wheeler tyres segment, it is now diversifying into passenger cars as well. Iit was only in 1995 that the company wiped out its entire carried-forward losses, thereby coming out of the BIFR dragnet. It actually registered increases on several fronts that year. Turnover at Rs 68 crore rose by 37 per cent while the net profit at Rs 1.03 crore witnessed a 148 per cent increase. In 1996, the company recorded a turnover of Rs 83.18 crore with a net profit of over Rs 6 crore, which was an increase of 55 per cent .Falcon has been both increasing capacity and launching new products in the last few years. It introduced 15 new and improved tyre designs, including those for the latest models of Bajaj Auto, TVS Suzuki, Escorts, Yamaha and Kinetic Honda.

5.CONDUCT – PRICING LIMIT PRICING

Limit Price is the price charged by the firms under imperfect competition, particularly by firms with high monopoly power, such as oligopoly, to entry of new firms. The price is higher that competitive price but is lower than profit maximizing price. The firms are willing forego some profits by charging a lower price as long as the potential entrants find entry non attractive. The extent to which price is lower than the profit maximizing level depends on the strength of the barriers to entry and the cost of production of the entrants. The various entry barriers give cost advantages to the incumbent ( established) firms. Hence the cost of the entrant is higher than the cost of the incumbent firms. Therefore the incumbent firms charge a price that is lower than their profit maximizing price level but higher than the competitive price. ie., the lower limit for the price is the competitive price level. The price will not cover the cost of production for the entrants. Thus entry is prevented. The following figure shows limit price.

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In the figure the profit maximising price and output is PM and XM. The competitive price and output is PC and XC. It is assumed that the industry is subject to constant cost conditions . Hence AC= MC in the figure. Below the monopoly price PM, demand is uncertain, due to possible entry. Hence to prevent entry, the incumbent firms charge a price of P L , and sell X L . The price P L is the limit price. It prevents entry of new firms in the industry. By charging P L, firms are able to forestall entry and retain their market share which would reduce if entry was possible. The PL will be less than the cost of the new potential entrants who don’t find entry in to the industry attractive any more. The incumbent firms will reduce price and prevent entry as long as the entry preventing price is not less than competitive price. That is the lower limit of limit price is PC. Hence the limit price PL will be less than PM but greater than PC. ie..,

( PM < PL > PC ) . Limit price PL is defined as :

PL = PC ( 1+ E ) , where E is the condition of entry. Condition of Entry E is expressed as:

The extent of deviation of from competitive price depends on the strength of the barriers to entry.When entry barriers such as product differentiation and advertisements are high , limit price PL will be high and closer to profit maximising price PM and entry barriers are weak, PL will be low and closer to competitive price. Thus strong barriers result in high limit price and weak barriers result in low limit price.

The limit price is based on the differences in costs between the incumbent firm (already inside the market) and the potential entrant. If the existing firms have managed to exploit some of the economies of scale that are available to firms in a particular industry, they

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have developed a cost advantage over potential entrants. They might use this advantage to cut prices if and when new suppliers enter the market, moving away from short run profit maximisation objectives - but designed to inflict losses on new firms and protect their market position in the long run.

Bain considered entry as the establishment of a new firm which builds or introduces new productive capacity that was not used for production in the industry prior to the establishment of the new firm. Thus for Bain entry is setting up of a new firm. Bain excluded from his entry concept the following:

Take over of an existing firm by some other firm. The expansion of capacity by an established firm.

Cross entry., entry by a firm that is already established in another industry.

Barriers to entry are those factors that deter entry by new firms in to the industry. Barriers to entry allow incumbent firms to earn positive economic profits, while making it unprofitable for newcomers to enter in to the industry. Barriers to entry are designed to block potential entrants from entering a market profitably. They seek to protect the monopoly power of existing (incumbent) firms in an industry and therefore maintain supernormal (monopoly) profits in the long run. Barriers to entry have the effect of making a market less contestable. If the barriers to entry are stronger the difference between PL and PC will be high. That is with strong barriers PL is closer to PM and with weak barriers PL is closer to PC.

Barriers to entry may be structural or strategic. Structural entry barriers result when the incumbent has natural cost or marketing advantages or benefits from favourable regulations. Strategic entry barriers result when the incumbent aggressively prevents entry. Such entry deterring strategies include limit pricing, predatory pricing and capacity expansion.

Barriers to entry into markets for firms include;

Investment, especially in industries with economies of scale and/or natural monopolies.

Government regulations may make entry more difficult or impossible. In the extreme case, a government may make competition illegal and establish a statutory monopoly. Requirements for licenses and permits, for example, may raise the investment needed to enter a market.

Predatory pricing - the practice of a dominant firm selling at a loss to make competition more difficult for new firms who cannot suffer such losses, as a large dominant firm with large lines of credit or cash reserves can.

Patents give a firm the sole legal right to produce a product for a given period of time. Patents are intended to encourage invention and technological progress by offering this financial incentive.

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Economy of scale - Large, experienced firms can generally produce goods at lower costs than small, inexperienced firms.

Customer loyalty - large incumbent firms may have existing customers loyal to established products. The presence of established strong Brands within a market can be a barrier to entry in this case.

Advertising - incumbent firms can seek to make it difficult for new competitors by spending heavily on advertising that new firms would find more difficult to afford.

Research and development & Product differentiation - some products, such as microprocessors, require a massive upfront investment in technology which will deter potential entrants.

Sunk costs - sunk costs cannot be recovered if a firm decides to leave a market; they therefore increase the risk and deter entry.

Network effect - when a good or service has a value that depends on the number of existing customers, then competing players may have difficulties to enter a market where a strong player has already captured a significant user base.

Restrictive practices, such as air transport agreements that make it difficult for new airlines to obtain landing slots at some airports.

Distributor agreements, exclusive agreements with key distributors or retailers can make it difficult for other manufacturers to enter the industry.

Supplier agreements, exclusive agreements with key links in the supply chain can make it difficult for other manufacturers to enter the industry.

Inelastic demand, a strategy of selling at a lower price in order to penetrate markets is ineffective with price-insensitive consumers.

Porter classifies the markets into four general cases:

High barrier to entry and high exit barrier - Examples: Telecommunications, Energy High barrier to entry and low exit barrier - Examples: Consulting, Education

Low Barrier to entry and high exit barrier - Examples: Hotels, Siderurgy

Low barrier to entry and low exit barrier - Examples: Retail, E-commerce

Those markets with high entry barriers have few players and thus high profit margins. Those markets with low entry barriers have lots of players and thus low profit margins. Those markets with high exit barriers are unstable and not self-regulated, so the profit margins fluctuate very much along time. Those markets with a low exit barrier are stable and self-regulated, so the profit margins do not fluctuate along time.

The higher the barriers to entry and exit the more prone a market tend to be a natural monopoly. The reverse is also true. The lower the barriers the more likely to become a perfect competition

Theoretically Bain has classified barriers in to four categories:

Absolute cost advantage barrier

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Economies of scale barrier

Product Differentiation Barrier

High initial capital requirement barrier.

Absolute Cost Advantage Barrier arise from the following situatios:1. skilled, expert management personnel not easily available to the new firms.2. control of supply of key raw material by established firms which makes these

available to new firms only at a very high price or compel them to substitute inferior raw material.

3. Patents and superior techniques available only to the established firms.4. lower price of raw material to established firms due to exclusive arrangement with

suppliers or because of bulk buying.5. lower cost of capital for established firms.Product Differentiation barrier :: Differentiated products make entry difficult for new firms. Product differentiation gives monopoly power to the firm and hence the firm is able to set a price that is closer to profit maximisation price. Product differentiation creates a brand loyalty among buyers for the firm’s product and thus acts as a strong barrier to entry. The entrant is at a disadvantage because he has to make his products known and attract some of the customary buyers of the established firms. To overcome this obstacle , either the new firm has to offer tits product a substantially low price than the established firms, or do heavier advertising or both. Such activities lead to higher costs for the new firms. Product differentiation strengthens barriers. If product differentiation is mild, then the barrier is weak and the firm will be forced to keep the price closer to competitive price. Strong product differentiation on the other hand will permit a price closer to monopoly power.

If price increases above PL , new firms enter and the demand curve of the entrant is d2. This will decrease the market share of the established firms. But if the established firms

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differentiates its product, raising the price above PL will not attract entry and the entrants demand curve will remain to be d1. Barriers form Initial Capital Requirement: Capital markets are almost inaccessible to new firms which has not established its reputation and banks are reluctant to finance new business. Hence new firms face high interest rates and thus new firms have a absolute cost disadvantage over established firms.Economies of scale Barrier: Economies of scale may be real or pecuniary. Real economies are those which reduce the input of factors per unit of output. Pecuniary factors are those which result from paying a lower price for the inputs purchased by the firm. Real economies are technical, managerial and labour economies while pecuniary economies arise from bulk buying at lower prices, lower transport cost etc. Established firms enjoy these economies extensively which reduces their production cost.As a result of these barriers the LAC of the established firms is always below the LAC of the entrant as shown below:

PREDATORY PRICING

Predatory pricing may be broadly defined as “pricing low with the intention of driving rivals out of a market or preventing new firms from entering. This activity can be harmful to new firms wanting to enter a new market. For consumers, predatory pricing is good in the short-run, but may be bad in the long-run if a firm which has used predatory pricing to establish a monopoly position then raises its prices to monopoly levels. The best example of predatory pricing is Microsoft's practice of giving away its Internet Explorer software during its browser war with Netscape.

Predatory pricing is one of the oldest big business conspiracy theories. It was popularized in the late 19th century by journalists such as Ida Tarbell, who in History of the Standard Oil Company severely criticised John D. Rockefeller because Standard Oil's low prices had driven her brother's employer, the Pure Oil Company, from the petroleum-refining business.(1) "Cutting to Kill" was the title of the chapter in which Tarbell condemned Standard Oil's allegedly predatory price cutting.

The predatory pricing argument is very simple. The predatory firm first lowers its price until it is below the average cost of its competitors. The competitors must then lower their

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prices below average cost, thereby losing money on each unit sold. If they fail to cut their prices, they will lose virtually all of their market share; if they do cut their prices, they will eventually go bankrupt. After the competition has been forced out of the market, the predatory firm raises its price, compensating itself for the money it lost while it was engaged in predatory pricing, and earns monopoly profits forever after.

The classic article on predatory pricing was written by economist John McGee in 1958.(4) McGee examined the famous 1911 Standard Oil antitrust decision that required John D. Rockefeller to divest his company. Although at that time popular folklore held that Rockefeller had "monopolized" the oil refinery business by predatory pricing, McGee showed that Standard Oil did not engage in predatory pricing; it would have been irrational to have done so. McGee was the first economist to think through the logic of predatory pricing. He concluded that not only would it have been foolish for Standard Oil to have engaged in predatory pricing; it would also be irrational for any business to attempt to monopolize a market in that way.

In the first place, such practices are very costly for the large firm, which is always assumed to be the predator. If price is set below average cost, the largest firm will incur the largest losses by virtue of having the largest volume of sales.

Second, there is great uncertainty about how long a price war would last. The prospect of incurring losses indefinitely in the hope of someday being able to charge monopolistic prices will give any business person pause. A price war is an extremely risky venture.

Third, there is nothing stopping the competitor (or "prey") from temporarily shutting down and waiting for the price to return to profitable levels. If that strategy is employed, price competition will render the predatory pricing strategy unprofitable--all loss and no compensatory benefit. Alternatively, even if the preyed-upon firms went bankrupt, other firms could purchase their facilities and compete with the alleged predator. Such competition is virtually guaranteed if the predator is charging monopolistic prices and earning above-normal profits.

Fourth, there is the danger that the price war will spread to surrounding markets and cause the alleged predator to incur losses in those markets as well

Fifth, the theory of predatory pricing assumes the prior existence of a monopoly profits that the predator can use to subsidize its practice of pricing below average cost. But how does that monopoly profits come into being if the firm has not yet become a monopoly?

Sixth, the opportunity cost of the funds allegedly used to try to bankrupt rivals must be taken into account. For predatory pricing to seem rational, the rate of return on predation must be higher than the market rate of interest; in fact, it must be higher than the expected rate of return on any other investment the predator might make, including "investment" in lobbying for protectionism, monopoly

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franchises, and the like. Predation is unlikely, given the great uncertainties about whether it would have any positive return at all.

Eighth, the predator can recoup its losses only if consumers cooperate. That is, the strategy will fail if consumers are able to stock up during the low-price predation period. If they do so, there can never be a post-predation recoupment period for the predator. And if the predator responds by limiting quantity, its rivals can step in and make up the difference by supplying additional quantities at a higher price. "A predator that puts a cap on sales thus [preys] against itself."

Ninth, is another problem related to the predator's ability to recoup his losses: the "victims" have strong incentives to ride out the price war, as discussed above, because of the lure of monopoly profits when the war is over. The capital markets, moreover, should be willing to finance the victims because they, after all, are not incurring as large a loss as is the predator. There is a risk, of course, in providing capital to the victims, but that risk can be attenuated by charging an appropriate interest rate. Thus, lenders may have a financial incentive to aid the prey. There is also the possibility that larger firms, which have their own "deep pockets," will acquire the victims if it seems profitable to do so.

Even if the victim goes bankrupt, the predator is by no means guaranteed a monopoly. The bankrupt firm's resources do not simply disappear; they may be acquired by another firm (possibly at fire-sale prices). Because the acquiring firm has lower fixed costs than the predator, it may be able to underprice the predator. The victim could also approach its customers and arrange for long-term contracts at a price above the predatory price. The customers would be willing to enter into such contracts if they realized that the current low price was to be followed by a monopolistic price.

Finally, it should be kept in mind that the anticipated monopoly profits of the predator must be discounted to their present value. The predator firm may realize that possible monopoly profits in the future are not worth lost profits today. If that is the case, predatory pricing clearly does not pay.

Predatory pricing is successful only under the following conditions:

When the discount rate is low.

When the predator has a large cost advantage over its rivals.

When the competitive fringe is relatively large.

When the members of the fringe exit quickly in response to price cuts.

When the market is segmented.

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When there is asymmetric information and uncertainty and substantial inter temporal linkages, the successful predation expands.

Establishment of reputation for toughness by predators.

Consumers do not stock up during low price predation period.

The victim firms are not able to make arrangements with finance companies or consumers to survive the predatory pricing attempt.

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CASE STUDYThe Times is or was a venerable newspaper. Since the 18th century, it was the most authoritative newspaper of Britain. It was almost royal. It displayed its heraldic arms on the masthead, and told its readers whom the King had given audience the previous day.. It had no news on its front page only classified advertisements which the nobility and the gentry used to communicate with one another. It had amazing access to the corridors of power; for that reason all in power, and many who did not, read it. Then came the swinging 60s; Britains post-war generation found The Times too stodgy. Professionals started reading The Daily Telegraph, while progressive intellectuals preferred The Guardian. Then came The Independent in the 70s; it combined news sense with excellent features.The Times was bought up by Rupert Murdoch, but it still lost readership. Then Murdoch started cutting the price, and making The Times more populist. Today it costs an absurd 10 pence on Monday; its content is populist. As a result, other newspapers are in serious trouble; The Independent is so badly off that it may close down. There is a Competition Bill in the British Parliament. On February 10, the House of Lords voted by 121 to 93 for an amendment to the Competition Bill outlawing predatory pricing.

Cellular operators have accused Reliance Info comm of offering predatory prices in Chennai and Tamil Nadu circles, and have sought telecom regulator Trai’s intervention immediately In a letter to Trai Chairman Pradip Baijal, the Cellular Operators Association of India (COAI) has said tariffs for pre-paid subscribers in Chennai and Tamil Nadu, for national and inter-circle calls, have been reduced to an extent, non-complying with Trai’s prescribed IUC regime. Trai had once dismissed the COAI’s allegation against Reliance, saying “differential tariffs in the retail segment were permissible and the service provider must be able to meet the IUC expenses on weighted average basis. But, the COAI has once again petitioned Trai citing reasons that the authority had applied different yardsticks in the case of Reliance for dismissing the charges. We are perplexed to note that the authority has applied different yardsticks for different service providers on the issue of weighted average IUC charges,” the association said.

PRICING BY DOMINANT FIRM

In the dominant firm pricing method, one of the firm in the oligopolistic market that emerges as a dominant firm by virtue of its higher market share emerges as a leader. Market

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dominance is an important feature of industrial structure that is attributed to mergers and innovations. The merger of Ponds with Hindustan Lever made Ponds a market leader. The Eastman Kodak, Gillette, AICOA, IBM and Xerox are example of firms that that emerged as dominant firms through innovations. The dominant firm has a considerable market share and the smaller firms have smaller market shares. Assuming homogeneous products, the dominant firms set the price and the smaller firms take this price as given. The dominant firm has complete information about market demand and is assumed to know the marginal cost curve of the smaller firms. From the marginal cost of the smaller firms the dominant firm derives the supply curve of the smaller firms. The dominant firm assesses its own demand curve by deducting from the market demand the supply made by the small firms. This is shown in the following figure.

In the figure, at each price, the dominant firm will be able to supply that part of the total market demand that is not supplied by the small firms. Thus at price OP1 the demand for the dominant firm is zero because the entire market demand is supplied by the small firms. As price falls below P1 the demand for the dominant firm. increases At price P2 > P1, supply by small firms is P2B and BL (P2L – P2B ) is demand for leader’s product. At P3 price supply by small firms is zero and the entire market demand belongs to the dominant firm. In his way the demand curve of the dominant firm is derived from which its MR curve is derived. Equilibrium of the dominant firm is where its MR = MC. The equilibrium price is OP and output is OX. At this price small firms will supply PA and dominant firms demand is AK = OX= PM. Dominant firm will maximize profit while small firms may or may not maximize profit.Pricing by dominant firm is adopted and followed by firms under oligopoly to avoid the uncertainty that arises from their inter dependence. PRICING BY LOW COST FIRM: Oligopolistic firms also adopt the strategy of following the price of low cost firm to avoid uncertainty. This typically happens under price leadership collusive models of oligopoly. In this a firm which has the lowest cost emerges as the leader and others follow its decision regarding price. At the price set by the leader the follower sell

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the output that their demand curve would permit. This type of pricing is illustrated in the following figure drawn assuming that there are just two firms A and B, of which firm A is the low cost firm and hence the leader.

It is assumed that the market is equally shared by the two firms in the market. Firm’s MC curve is below firm B’s MC curve. By virtue of its low cost firm A is the leader and B becomes the follower. Firm A’s equilibrium is at eA where MCA cuts MRA ( = MRB). The equilibrium price and output is PA and XA. B would sell the quantity at the same price. Thus XA = XB. Instead if B were to act independently, it would charge a price according to its MC curve, MCB and the equilibrium is at eB. The equilibrium price for B is PB at which it will sell X’B. and earn super normal profits. But soon A would react to this and a price war would follow. Such price war can be avoided if B chooses to follow A and sell at the price fixed at A’s equilibrium.Discriminatory Pricing: Read from Micro Economics Text Book.

6. CONDUCT – PRODUCT DIFFERENTIATION

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PRODUCT DIFFERENTIATION

Product differentiation is an important strategy for market dominance, in which firms develop distinctive varieties that are close but not perfect substitutes. Firms produce differentiated products to increase their market share and to limit entry. Product differentiation acts as a strong barrier to entry. Product differentiation as the basis for a downward sloping demand curve was first introduced in economic theory by Sraffa. The implications of using product differentiation as a selling strategy by the firm was analysed by Chamberlin.

Product differentiation is intended to alter the shape and position of the demand curve. It is intended to distinguish the product of one firm from that of the other in the industry. The aim of product differentiation is to make the product unique in the mind of the consumer. It can be real or fancied. It is real when the inherent characteristics of the product are different. It is fancied when the products are basically the same, yet the consumer is persuaded via selling and other activities that the products are different. Real differentiation exists when there are differences in the specification of the products or differences in the factor inputs. Fancied differentiation is established by advertising, differences in packages, differences in design or simply by brand name. Product differentiation could be horizontal or vertical. Horizontal differentiation occurs when a market contains a range of similarly priced products. An increase in the range of products means that consumers will on an average be able to find a product which meets their preferences more exactly.

Example: (a) competing firms may produce the same quality of carpets, but each carpet has a different colour or design.(b) recording firms produce records of the same quality but with different types of music such as classical, jazz, disco etc. Vertical differentiation occurs when products differ in respect of quality and there is difference in the cost of producing the various products.Example: Cotton- polyester mix in textile, cassets playing for 60 mnts / 90mntsA general model of product differentiation The basic model of product differentiation as explained by Lancaster considers characteristics of good rather than the good itself to be the object of consumer preferences. Goods are seen as bundles of characteristics and differentiated goods are treated as goods which combine the same characteristics in different proportion. Lancaster model considers product ( soap ) with 2 characteristics. Let these two characteristics be fragrance ( α ) and lather ( β).In the following diagram 3 rays A, B and C are shown for 3 soaps with 3 different proportions of α and β. Ray A shows most lathering soap and ray C shows most fragrant soap while Ray B shows a soap with a modest combination of both fragrance and lather. Points E , F, and G are show amounts of each good that can be bought for equal expenditure on each. The location of these points, hence, depends on the price of each soap.

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In the figure Within the characteristics space between the X and Y axis, any number of rays could be drawn representing different combinations of fragrance and lather. The interdependence between firms depend on two things.

a. number of characteristics in the marketb. number of firms in the industry.

The stronger the products are differentiated, weaker will be the interdependence , the further apart will be the rays in the diagram. A firm can change the nature of its product and there by move the ray in the characteristic space or introduce a new differentiated product and introduce a new ray. It is more likely to be profitable if a gap in the market can be spotted. An area of characteristic space already crowded with rays, that is, a market crowded with varieties of product, is less attractive. Vertical product differentiation: Vertical product differentiation brings about changes inherent quality of the product and results in significant changes in cost. The firm in its pursuit of increasing the market share brings out improvement in quality which shifts demand and cost curves upwards. In the following figure, with every improvement in quality, demand curve shifts upwards from D1 to D5, but at a decreasing rate, implying that consumer’s tastes become saturated as quality improves. The unit cost to the firm for each quality is X1a1, X2a2, X3a3 and so on. The firm breaks even with grade 3 – average cost X3 e is equal to price P. Further improvements in products do not bring profits. In fact beyond X3 output level, firm incurs losses. Joining the relevant unit cost pints for respective out put level we get the Average Cost Option Curve (ACOC ).

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The ACOC shows the unit cost of supplying the different quantities demanded of different qualities at a given price P. As quality improves ACOC shifts upward. Shape of ACOC shape and position of the average cost curves. In the figure, upward slope of ACOC is because of the higher unit cost of producing an improved quality of the product. Upward shift. of the demand curve is because of the improved quality.Initially ACOC will decline because shift of demand curve will be greater than shift of cost curve but eventually ACOC will rise upward because the shift of the cost curve will be greater than the shift of the demand curve. Since it always pays the firm to improve its quality the rising segment of the ACOC is relevant for decision making. The firm is in equilibrium when MCO cuts price line at e in the following figure. At equilibrium the firm is making a profit of PeBA. This profit will attract entry and ACOC shifts upward while demand curve shifts downward. This will stop when ACOC becomes tangent to price line as shown in the diagram. This is a long run equilibrium and the firm may be producing the same level of output at higher cost.

Product Differentiation And Barriers to Entry: Differentiated products make entry difficult for new firms. Product differentiation gives monopoly power to the firm and hence the firm is able to set a price that is closer to profit maximisation price. Product differentiation creates a brand loyalty among buyers for the firm’s product and thus acts

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as a strong barrier to entry. The entrant is at a disadvantage because he has to make his products known and attract some of the customary buyers of the established firms. To overcome this obstacle , either the new firm has to offer tits product a substantially low price than the established firms, or do heavier advertising or both. Such activities lead to higher costs for the new firms. Product differentiation strengthens barriers. If product differentiation is mild, then the barrier is weak and the firm will be forced to keep the price closer to competitive price. Strong product differentiation on the other hand will permit a price closer to monopoly power.

The figure illustrates the significance of product differentiation as an entry barrier. The firm’s profit maximising price is PM and entry preventing price is PL. With PL as the price, entry is prevented and the entrant’s demand curve is d1or may be even below that.

If price increases above PL , new firms enter and the demand curve of the entrant is d2. This will decrease the market share of the established firms. But if the established firms differentiates its product, raising the price above PL will not attract entry and the entrants demand curve will remain to be d1.

Product Differentiation and PerformanceProduct differentiation is the cause for the downward slope of the demand curve. By making the product unique in the mind of the consumer and by creating brand loyalty, product differentiation confers monopoly power to the firm to some extent. As result the output of the firm is not an efficient output. With a downward sloping demand curve the firms’s long run equilibrium is established with excess capacity. Even if number of firms is large and long run equilibrium generates just normal profit as under monopolistic competition, the excess capacity can not be avoided. There is always an unused capacity in the plant at equilibrium. The inefficiency will be larger when the number of firms if fewer as under oligopoly. The price will be greater than marginal cost ( P > MC) . The difference between price and marginal cost will be greater with restricted entry. This is shown in the following figure.

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7.CONDUCT – ADVERTISEMENT

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Advertising is any paid form of non personal presentation and promotion of ideas, goods, or services by an identified sponsor. For the firms in any industry it is an important tool of marketing. Its role is to implement product flow through the channels of distribution: to act as a catalyst in acquainting the consumer and to induce him to buy the product. Form the point of view of economic theory advertisement is the expense incurred by the firm as part of its selling strategy to alter the shape and position of the demand curve. Advertising is the selling expense incurred by firms to alter the shape and position of its demand curve. Selling expenses such as advertisement add to costs in order to add to demand. They are an alternative to price – cutting as a competitive tactic. They are safer than price cutting and are not likely to cause as much mutual harm among rivals as price - cutting would.Advertising and market structure: Advertising has become a major means of competition in the modern oligopolistic world. In pure competition selling expenses are irrelevant. Price is given by the market and the firm’s selling efforts can not influence the flat demand curve. In pure monopoly selling expenses can have a limited role. They can used to reduce demand elasticity so as to increase profits to the firm. Advertising may also sharpen any difference in elasticity among consumer groups which will increase the scope for price discrimination. Yet on the whole monopolist need not make much selling effort. It is in the intermediate range of monopolistic competition that advertising becomes a significant tool of competition. Advertising is essential not only for increasing ones’s market share but even for maintaining existing market or sales. Defensive advertising is routine under oligopoly. The greater the consumer’s responsiveness to changes in the product price, higher will be the optimal level of advertising relative to sales. In markets characterized by oligopoly it is usually argued that advertising and other forms of promotional activity play a more important role than price competition. Advertising intensity hence varies with the level of concentration as shown in the figure below:

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Under oligopoly changes in price can be spotted easily by rival firms and generate a rapid response that may have a detrimental impact on the initial firm’s profit which is compelled to counteract with heavy advertisement. Hence advertisement is higher under oligopoly. Dorfman and Steiner state that advertising will tend to be higher when demand is inelastic and MC < price. In short advertising is related to monopoly power of the firm.Impact of Advertisement on Demand: Advertising shifts the demand curve of the product upwards thus increasing the quantity demanded at the given price P. Initially advertising shifts the demand curve at an increasing rate. However beyond a certain level of advertising, demand increases at a decreasing rate since the preferences of the consumer gets saturated for the product. The shift of the demand curve with advertisement is shown below.

In the figure an advertising expenditure of a constant amount of , say , “k”, shifts demand curve from D1 to D6 position. With price constant at P, initially advertising increases quantity demanded by Q1Q2, then by Q2Q3. Further doses of advertisement increases quantity demanded by Q3Q4, Q4Q5, and Q5Q6 . It can be seen in the figure that Q3Q4 > Q2Q3

> Q1 Q2 and Q4Q5 < Q3Q4 and Q5Q6 < Q4Q5. Thus it is clear that demand increases in response to advertisement but at a decreasing rate. The advertising expenditure curve takes a sigmoid shape.

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The shape of the advertising expenditure curve implies that initially advertising increases the demand at an increasing rate. However beyond a certain level of advertising, A3 in the figure, demand increases at a decreasing rate. The economic meaning of sigmoid shape is the following: at low levels of advertising expenditure, its effect on the quantity demanded is negligible as the number of advertising message and / or number of the media is small. As advertising increases consumers are attracted to a great extent. However beyond a certain level it becomes difficult to persuade consumers through advertising. Advertisement as entry barrier Oliver Williamson has developed a model in which an oligopolistic firm uses advertising to prevent entry. Thus the goal of the firm is to prevent entry by choosing an appropriate level of advertisement and charge a price that impedes entry of new firms into the industry. Advertisement will help the firm to charge a price closer to profit maximizing price. With increase in advertisement expenditure the price approaches profit maximizing price. This is shown in the following figure. Williamson assumes that barriers to entry increases with advertising expenses. Hence the limit price PL is an increasing function of advertising. Any point on PL PL curve and below it implies a price advertisement strategy that prevents entry. At any point above PL

PL entry is not prevented. At equilibrium the firm will choose a point on PL PL. The intercept PL is the limit price without advertising. It reflects barriers arising from scale economies and absolute cost advantage. As advertising increases, so does entry barrier and hence the price PL, which the advertising firm can charge with out attracting entry will also increase. The shape of the PL PL curve indicates that low levels of advertising would not erect high barriers since potential entrants can match the advertisement expenditure of the established firms fairly easily.

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At high levels of advertising however the burden from selling expenses increases on potential entrants increases strengthening the barrier and PL. However eventually the curve flattens out because of limit to the effectiveness of advertising in deterring entry. The position of the curve depends on the nature of the product. Three curves corresponding to high, substantial and low barriers to entry are shown below.

Cosmetics, drugs liquor,, soft drinks would have a high PL curve since for these products advertisement can create strong buyer preferences. Canned food, furniture and house hold goods have a substantial PL curve and some textile forms such as rayon have a low PL

curve.

Advertising, Barriers to entry and Profitability: Advertising perpetuates oligopolistic market structure by creating or strengthening existing barriers to entry in the following ways.

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1. Advertisement and preference barrier: Advertising is one of the most important ways of differentiating a product. To the extent that advertising creates brand loyalty , potential entrants face a significant obstacle to attracting customers from existing firms.2. Advertising and absolute cost advantage: A new entrant must incur some penetration cost in order to establish himself in the market. In general the penetration cost represents an investment in order to establish a market position. They consist mainly of extra advertisement outlays which are required for entry. Established firms need not incur penetration costs, while an entrant must advertise heavily to break buyer’s brand loyalty and inertia. The unit cost of market penetration are likely to increase as output expands because it becomes increasingly more difficult to attract customers who are more inert or loyal, with strong brand preferences. This effect of advertising creates absolute cost advantage for established firms.3.Advertising and scale economies: There are real and pecuniary economies of scale of advertising. In each industry there is a certain amount of advertising expense that must be incurred by each firm in order to stay in the market and maintain its share. Larger firms have the advantage of being able to spread this cost over a larger output, so that the unit cost of advertising is less for larger firms than for smaller firms. As a result, smaller firms, including most entrants, are placed at a strong disadvantage. The scale disadvantage of a new entrant will be greater if the established firms react to entry by increasing their advertising. To sum up, there is minimum optimum scale of advertising , which if super imposed on the production scale economies, may result in a larger amount of output which the entrant must sell in order to reap all the economies of scale.(production and advertising) . Thus advertising may increase the minimum efficient plant size.4.Advertising and the initial capital requirement barrier: The market penetration costs increase the capital requirements of a new entrant. If there are economies of scale in advertising, entrants will have to spend more on advertising ; thus financing of advertising will not only require additional initial funds but will also be more costly. The above effects of advertising on the various barriers are shown in the following figure.

To enter a market of advertised goods, a new firm must meet penetration cost which are rising in the figure shown as by AMPC curve. This is because gaining a larger market share requires sharply rising advertisement efforts. In the figure curve total cost for

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an entrant ( production cost + advertising cost + penetration cost ) are higher than those for an established firm with established brand images. This opens up a barrier whose height is shown. It also reduces slightly the optimal scale for the entrant from Q2 to Q3. Among established firms, advertising has a further effect. Average advertising costs ( AAC ) show economies of scale. This increases the optimal size of the firm from Q1 to Q2. This places smaller firms at a cost disadvantage and tightens oligopoly. The whole effect is to let established firms raise price up to the limit price level of P3. Without selling costs price would instead be at price P1.The increase from P1 to P3 is advertising’s effect. The degree of market power is higher and entry is impeded. Factors determining advertising outlay:Differences in advertising level are influenced by differences in product characteristics and by differences in market characteristics. Consumer goods are more heavily advertised than industrial products. Within consumer goods sector, advertising intensity is generally higher for non durable goods. Advertising intensity is the ratio of advertising expenditure to sales revenue, ( A / P.Q ). Consumer goods have a longer life, are often more complex goods and tend to involve a greater outlay than consumer non durables. Hence an error of judgement in purchasing a durable good will have a greater effect on the consumer’s welfare. Consequently consumers will require more information than can be effectively communicated via advertising. The more complex a product, the greater the greater the use consumers make of alternative information sources such as consumer publication. Hence with durable goods advertising is also likely to be less effective in promoting sales than competition on the basis of price. When knowledge is imperfect consumers can improve their decisions by searching for information on product characteristics, product availability and alternative prices. Search for durable goods will be higher than for non durable goods. Search will be lower for goods purchased frequently and for goods which account for a low proportion of consumer’s total expenditure. The more a market is changing the higher will be the level of advertising. Where there is rapid turnover of customers as in the case of baby food market, there will be heavy advertising to inform new consumers. Where product characteristics change rapidly, there will be a need to advertise to increase consumer’s awareness. Advertising levels will also be relatively high where the entry of new firms is rapid. Firms entering the market will have to counter act the influence of past advertising of existing firms by advertising heavily to inform consumers of the attributes of their own products.

**************** 8. MERGERS

Mergers involve the amalgamation of two or more independent firms under one control. A merger combines two or more firms into one. The firms may differ in size with one absorbing the other. The merger may occur amicably or under tension or both. Merger may be of three kinds.

a. Horizontal mergerb. Vertical mergerc. Conglomerate merger.

Horizontal merger involves merger among firms selling a similar commodity. If two manufacturing firms merge, it is a horizontal merger. If a group of firms, all producing

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steel, merge into one, that is also horizontal merger. Horizontal merger invariably raises market power by eliminating side by side competition between firms. The effect may be small or large, depending on the two firms’ market and on other conditions of market. The merger of Ponds with Hindustan Lever is an example of horizontal merger.Vertical merger occurs when one firm merges either with a firm from which it purchases an input or with a firm to which it sells its output. Vertical merger occurs when, for example, when a coal using electric utility purchases a coal mining firm or when a shoe manufacturer purchases a retail sale unit. Steel industry is an example when a larger firm tries to embrace all stages – mining, shipping, ore blast furnaces, rough rolling, steel furnaces, finished rolling, fabricated products. The vertical merger ties together firms in a chain of production. A conglomerate merger does not have any technical relationship or connections among the activities of the firm. Conglomerate mergers could be product extension or market extension. A product extension merger occurs when firm X adds a product related to its existing product line by buying up firm Y.Example; A diversified food product firm buys a company selling coffee.A market extension merger combines two firms selling the same product in different geographical locations.A pure conglomerate merge has none of these connections not any technical relationships among the activities of the firm.Motives for Merger There are several motives for merger, the most significant among them being:

1. Search for market power.2. Search for efficiency.3. Motive for maximizing profits4. Reducing tax liability 5. Diversification of risk

1.Search for market power: A merger can increase the market power of the merged firm. In the case of the horizontal merger, if all or most of the firms in an industry merge, the survivor becomes a dominant firm. The survivor firm will be able to exercise control over price: it will charge limit price, restrict entry and maintain its position. Vertical merger by one or more established firms in an industry can have a profound effect on market share and on the degree of competitiveness by erecting barriers to entry. The merger firm will be able to prevent entry altogether if it controls either the supply of an essential input or all distributive outlets. Barriers to entry may be heightened if an existing merged firm refuses to supply or purchase from new entrants or will do so only on favourable terms. The merger of Universal Luggage with Blow Plast is an example of merger to limit competition and to enhance market power. Before merger both the companies were competing with each other leading to a severe price war. After the merger Blow Plast obtained strong hold on the market and now operates under near monopoly situation. Yet another example is the acquisition of TOMCO with Hindustan Lever in 1993. Lever expected to cover one third of the market for soaps and detergents after the merger.

2.Search for efficiency:

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Mergers have the effect of transferring control of the firm from less efficient to more efficient administrative terms. Horizontal merger is a way for a firm to acquire additional plants. By so doing a firm will be able to take advantage of any available economies of multi plant operations. By operating more than one plant a firm can spread the fixed cost of administration over a larger output. The result is a multi plant economy of scale that will encourage multi plant operations at least to the point where the firm becomes so large that management loses administrative control. If transportation costs are high firm will choose to operate several plants in each geographic market. There will often be product specific economies of multi plant operation. If a firm produces different products in a single plant, production time will inevitably be lost as assembly lines are switched from one product to another. By operating more than one plant the firm can specialise in the production of high volume products in single plants. This will result in run length economies. A firm that assumes control of many plants will be able to close the oldest and least efficient ones which eliminates excess capacity.Vertical economies arise from joining firms at two levels of production. For example, combining iron and steel operations so that pig iron and steel ingots can be sent to the processing level directly without losing heat thus reducing operating costs; saving of transporting cost from locating two vertically integrated processes in the same plant.Economies arise from conglomerate mergers too. The whole firm may be stabilised by combining disparate activities. Financial guidance and flows may be superior in diversified firms. Also synergy may result from interaction among differing technology and management within a conglomerate. Merger and profits : Horizontal merger increases the market share of the dominant firm, at least marginally. The economies from merger reduces cost while demand curve shifts upward due to increasing market share facilitated by merger. In the post merger period output will increase, but price will increase or decrease depending on elasticity of demand. Even if demand remains unchanged in the post merger period, or leads to only insignificant changes in market share of the firm the lower cost in the post merger period will increase profits. In the following figure the increase in profits arising from horizontal merger, with demand remaining unaffected is shown.

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In the figure profits before merger is P1AB C and profits after merger is P2 DKR. It is clear in the picture that P2 DKR > P1AB C .

Vertical merger also increases profits of the firm. Since vertical merger integrates two firms in different stages of the same product , substantial reduction in transaction cost results from vertical merger. By integrating vertically and turning suppliers of inputs into employees the firm can ensure their loyalty and straight forwardness with certainty which is not possible across markets. Vertical integration solves the small number bargaining problem that arises when there are only few possible suppliers. Merger increases profits due to cost reduction and efficient utilization of resources. This may happen because of the following reasons:

Economies of scale leading to optimum size Operating economies Synergy

A firm in the post merger period can consolidate its management functions and reduce operating costs. For example a combined firm can eliminate duplicate channels of distribution or create a centralised training centre or introduce an integrated planning and control system. An example of a merger resulting in operating economies is the merger of Sundaram Clayton with TVS Suzuki Ltd. By this merger, TSL became the second largest producer of two wheelers. Synergy refers to benefits other than those related to economies of scale. Operating costs are one for of synergy benefits. But apart from operating economies synergy may also arise from enhanced managerial capabilities, creativity, innovativeness, and R & D and market coverage capacity due to complementarity of resources and a widened horizon of opportunities.Apart from reasons like efficiency, market power, and greater profits , mergers arise due to strategic reasons too, such as

to raise rival’s input cost. to increase the absolute cost of entry to save a failing firm – a failing firm may be salvaged by merger with a healthy firm.

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The presence of negative externalities from inefficient services may serve as an impetus fro merger. Large petroleum companies may own filling stations rather than supply independent retailers since the retailers may provide inefficient service which will affect the business of the petroleum company. Merger ensures efficiency of service at retail stage in service.

Tax benefits arise when a profit making firm merges with a loss making unit thus using the loss to evade the tax.

To spread risks. This is particularly rue of conglomerate mergers which combines firms in unrelated business by stabilising the firm’s income in the post merger period. For a firm that operates in a single market, its sales and profits are tied to the market conditions that is beyond its control . If the firm diversifies into unrelated markets it may be able to even out fluctuations in income stream. If a firm operates in 3 or 4 markets, all the four will not fail at a time. If one is sick , one of the other three will compensate losses from the sick unit. Hence large firms which seek to spread risk and seek fast growth prefer conglomerate merger.

9. INVENTION AND INNOVATION

The use of product differentiation as an instrument of competition depends on the level of expenditure and effort committed by firms to the development and introduction of new products and also new methods of production, that is , funds allocated for R & D activities. R & D department of any firm conducts research aimed at the discovery of new knowledge, its applications as well as application of existing knowledge to the production of new products or for introducing new processes of production. Such activities of the firm are in simple terms termed as “technological change.” The process of technological change is a complex one. Schumpeter distinguishes between three main stages: invention, innovation, and diffusion. Invention is the production of new knowledge in the form of a new product or new process for production. It is the creation of a new technology. Innovation is the process of adopting an invention in a practical use. Innovation is a multi dimensional concept. A change in the existing product line of a firm through the introduction of a new product, is product innovation. If a new method of producing the existing product is introduced it is process innovation. Changes in product line and production process by a new product and production method respectively are instances of technological innovation. Market innovation on the other hand is the change in the marketing strategies.Similarly one may have innovation in organizational practices, financing and any other aspect of business conduct. The concept of innovation is thus very broad. The third stage diffusion is the stage when a product or process innovation is spread throughout the market either through the efforts of the innovator or as a result of imitations by other firms. Diffusion is a situation when an innovation is copied by others, that is, innovation spreads across the market. The three stages, invention, innovation and diffusion are the successive stages of technological change. Imitation is not possible without innovation and innovation is not possible with out invention.Innovation and market concentration

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In Schumpeter’s terminology, innovation is the intrusion in to the system of new production functions by exploiting an invention .. by opening up a new source of supply of materials or a new outlet for products by reorganising an industry and so on.”Schumpeter identifies five types of innovation. the introduction of a new product or a service or an improvement in the quality of an existing product or service.

The introduction of a new method of production. The development of a new market. The exploitation of a new source of supply The reorganisation of methods of operations.

Firms have an incentive to innovate and introduce new ideas. The assumption of imperfect knowledge ensures that innovators will be rewarded by a period of abnormal profits before it is subsequently eroded by rivals. Patenting the new process or product can only slow down the diffusion process. This is because the published patent specification itself acts as a source of information which rivals may use to help develop methods of imitation that circumvent the existing patent. Innovation ( R & D ) and firm size: Empirical studies reveal that large firms have certain crucial advantage. Galbraith argued that the high costs of modern day research are such that only large firms have the necessary resources to carryout the work. In addition large firms are better placed to handle the high risks associated with R & D work. The small form may have to concentrate its efforts on developing a single innovative idea, the success or failure of which may make or break the firm. The large fir on the other hand is able to support several projects simultaneously and failure in one area will be more than made good by success else where. Large firms have a further advantage when there are substantial economies of scale in R and D work. For instance they are better able to afford the specialist staff and expensive equipment which may be needed. The marketing power of large firms may also be important in inducing a high level of R & D expenses . Established links with distributive outlets, heavy advertising and other sales promotion expenditure will allow large firms to penetrate the market more quickly with new products and increase their return on R & D investment. In the case of process innovations that reduce cost, the larger firm’s advantage is that the lower unit cost apply to a larger output total savings are greater than they will be for a small firm. Empirical studies reveal that almost all large firms engage in R & D activities but only a fraction of small firms do so. The contribution of small firms to invention is found to be much greater than their contribution to the commercial application of new ideas where the costs involved are so much higher.R & D and market structure: From the point of view of industrial policy a crucial question is what kind of market structure is most conducive to R & D and thus to the promotion of technological change. Arrow argued that a purely competitive industry would provide greater incentive for cost reducing innovations than would be simple monopoly. The argument for a large cost reduction is shown below.

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The figure compares the results of process innovation under pure competition and monopoly. Process innovation results in a downward shift in the marginal cost curve from MC1 to MC2. Cost conditions are assumed to be identical for the monopolist and the perfectly competitive industry and pre innovation output for both is OQ. As a result of innovation the monopolist expands output to OQM where MRM = MC2. The competitive firm expands output to OQc where MRc = MR2. Given the cost of innovation the return to competitive firm exceed that of the monopolist by ABC.

Monopolist’s position before and after innovation:Change in output as a result of innovation = QQM

Change in TR = QABQM

Change in TC = QDBQM Net benefit from innovation = QABQM -- QDBQM = DAB ( in the figure).

Results of innovation under perfect competition:

Change in output as a result of innovation = QQC

Change in TR = QACQC

Change in TC = QDCQC Net benefit from innovation = QACQC -- QDCQC = DACB ( in the figure).Difference between the benefit under monopoly and perfect is: DACB – DAB = ABC.

Thus the return to the competitive firm exceed that of the monopolist by ABC. This result is due to the fact that following a cost reduction output is expanded more by the competitive firm than by the monopolist. However this results on the assumption that a single firm in the competitive industry is of the same size as a firm with monopoly power. In fact if, following an innovation all firms in the competitive industry were to expand output price would fall and the above analysis may not hold.Oligopoly, market power and innovation:

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Schumpeter felt that high concentration encourages innovation. He argued that monopoly power is necessary for a high level of R & D activity. A firm with substantial degree of monopoly power is necessary for a high level of R & D activity. Tjis is because:

1) A firm with monopoly power has greater incentive to innovate in the form of either creating or strengthening market power further. The innovating firm can expect to appropriate a larger share of gains from any innovation. In highly competitive market with large number of firms innovation is rapidly imitated by a large number of competitors leaving insignificant financial gain to the innovating firm. Thus there will be no incentive to invest in R& D if the market is shared by large number of firms. Thus large number of equally matched firms and easy entry conditions may not encourage innovation.

2) Firms with market power has large profits from which it can finance R & D activity.

3) Firms with market power have a greater degree of certainty about their future prospects which gives them incentive to face risks associated with R & D also equip themselves adequately for R & D effort. This market power makes it easier for them to engage staff on projects which may take several years to yield result. A firm with market power is thus in a better position to take the long run view necessary for mush R & D work because management is not completely absorbed in the short run struggle for survival.

4) Besides the gains arising from market power oligopolistic firms also have the competitive advantage that provide the best frame work for a high level of R & D. Although firms in an oligopolistic industry may collude on price it is more difficult to collude on R & D. Unlike a price cut successful innovation will atleast give it a temporary advantage over its competitors.

5) Competition between firms has the advantage that there are several centers of initiative so that different approaches to design or solving a technical problem will be adopted.

6) However the case for oligopoly as the most conducive market structure is limited since innovation does not offer any for an appreciable increase in market share in an already concentrated market. Further a dominant firm which is not threatened by entry may be slow to innovate because of its vested interest in existing products or processes. Innovation brings an end to the monopoly profits from outmoded products or processes and the protected dominant firm will thus tend to delay the introduction of the innovation. However a dominant firm react vigorously to the innovative activity of a smaller firm by rapid imitation or acquisition.

7) Having competitors will give incentive to innovate and result in improvement in the quality of innovation. Starting from monopoly, an increase in the number of firms could up to a certain point have beneficial effects. It would increase the competitive stimulus to innovate.Besides the size of the firm and market structure, size and growth of markets also affect R & D. For a given size distribution of firms, larger the market greater the expected returns from successful innovation. Similarly a rapidly increasing industry will promise higher returns to R& D than a declining one. Opportunities for innovations are higher in science based industries such as pharmaceuticals, electrical, electronics and engineering than most others.

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8) Innovation as market failure:There are reasons to believe that the amount of resources allocated to R & D will not be optimal. Three main arguments have been given to suggest that too few resources will be allocated to R & D activity so that some action by government is called for. These arguments are associated with: The cost and risk of R & D The public good nature of R & D The distinction between basic and applied research

Cost and Risks of R& D: For an individual firm the return to R & D expenditure can not be predicted; large amounts may be spent on research with out making any worthwhile discoveries. The element of risk inherent in R & D activity means that risk averse firms will invest too little on R & D activity from the resource allocation point of view. The more risky the project the more serious the under investment. This can be overcome if firms insure against the probable losses from R & D activity. However the risks from R & D are not insurable because of the unpredictability and moral hazard. Moral hazard is an hidden action problem where the insure does not have any incentive to be efficient in innovation; once it is insured the firms could commit resources to extravagant projects. Instead the government can bear the risk of failure through the specification and funding of cost plus research contracts which also eliminates incentive to minimize costs. Public good characteristics of R &D: The information of the R & D expenditure possess two characteristics of indivisibility and inappropriability. Information is indivisible because its use by person or firm does not prevent it being used at the same time by others. Thus the opportunity cost of using information is zero. In order to achieve a social optimum it should be available a zero price.( MC = P ). But to encourage firms to invest in R & D it is necessary to guarantee an inventing firm exclusive rights on the information it produces for a limited period atleast. But such a guarantee can not be made because information is inappropriable. It is extremely costly to exclude interested parties from the benefits of information. This applies particularly to product inventions – as soon as new product is available on the market other firms will be able to copy it and thus appropriate some of the benefits of R & D paid for by the initiating firm. Where the invention is a new manufacturing process rather than a new product it is easier for the firm that did the research to keep the new knowledge to itself, but the firms in the same industry may have the know how to work out how the new process functions. Once a new invention has been developed it is therefore impossible for the inventor to secure all the economic gains from his inventions: the costs of excluding other interested parties from the benefits may be too high. Also efficient resource allocation insists that knowledge should be freely available and rules out exclusion. But treating knowledge as a public good and making it generally available would completely destroy the individual firm’s incentive to innovate.Basic Vs applied Research: Applied research has a reasonably immediate commercial application to one particular technology, particular product or industry. Basic research on the other hand is concerned with the advance of scientific knowledge generally and may come up with findings of interest to a number of different industries or to none. Basic research is of fundamental importance because its discoveries will later serve as the inputs for further applied research project with commercial outputs. Therefore in order to encourage R & D expenditure as whole it is essential to invest sufficient funds in basic

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research. The problem of uncertainty and public good characteristic apply most strongly to basic research than applied research. From the point of view of an individual investing firm, the pay off is more uncertain, the further the research project is towards the basic end of the spectrum. The wide implications of the basic scientific discoveries increase the desirability of making the results freely available and hence spillovers are higher. Hence basic research suffers face the problem of inadequate funding. The problems arising due to public good characteristic features of invention the risks and uncertainty associated with innovations may be over come by direct allocation toR & D by the government , particularly for basic research, and by encouragement for joint venture and by patenting. Joint venture is a co operative approach to R & D with the benefits of risk spreading and limiting fast diffusion of knowledge. It ensures that benefits of invention are appropriated by the co operating firms.A patent system gives the legal protection against the appropriation of the benefits from this information by other interested parties, for a certain period of time. But to obtain a patent the inventor has to disclose full details of the process or products concerned. This ensures that as patent expires the information becomes freely available. While the patent is in operation other firms have no legal right of access to the information unless the patent holder abuses his monopoly position. The patent holder may license other firms to use it if they pay either a flat sum or a royalty payment which depends on the amount of the product made under license. Patent protection increases the market power of the existing firm by creating another barrier to entry. A patent holder can restrict output and raise price for the product for which it holds patent. Hence it is suggested that there should be a reduction in the degree of protection extended to a patent holder for the sake of both reducing market power and for encouraging rapid dissemination of new knowledge. This could be done by limiting the length if the period for which the patent I s given.Conclusion:Innovation measured by the R & D expenditure of a firm is thus a crucial component of decision making of the firm. It influences the performance of the firm - whether the firms are productively efficient, avoiding wasteful use of available resources. By influencing cost, price, output and profit of the firm, innovation influences allocative and productive efficiency of the firm.

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10. PERFORMANCE

Performance of a firm is in general measured in terms of Profit Efficiency Capacity utilization Profitability - Returns to capital

Profits: Economic theory views firms as profit maximisers. Profits are maximized when the two marginal conditions are satisfied. These are:

1. Marginal Cost = Marginal Revenue2. Marginal Cost curve cuts Marginal Revenue from below.

The profit maximising equilibrium of a monopolist is shown below: Figure 10.1 Equilibrium of a Monopolist

The monopoly firm in the figure drawn above is making a super normal profit of PRFT at the equilibrium price OP by selling OX.Performance in terms of Efficiency: Efficiency in simple terms refers to maximizing output from a given total of inputs. It implies absence of wastages. There are two categories of efficiency:

1. Internal efficiency or productive efficiency – X efficiency and X inefficiency 2. Allocative efficiency.

Internal or productive efficiency is achieved by excellent management within the firm. The objective of a firm is to minimize cost and maximize profit. When actual costs are greater than minimum possible costs due to factors such as managerial deficiencies, X inefficiency arises. x-efficiency is the effectiveness with which a given set of inputs are used to produce outputs. If a firm is producing the maximum output it can, given the resources it employs, such as men and machinery, and the best technology available, it is said to be x-efficient. x-inefficiency occurs when x-efficiency is not achieved. The concept of x-efficiency was introduced by Harvey Leibenstein in 1966. X efficiency and x inefficiency are illustrated in the following figure. Figure 10.2 X - Inefficiency

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In the figure output Q’ and Q” can be produced at the lowest cost Q’M and Q”M respectively if the average cost curve is AC. The same outputs cost Q’A and Q”C on AC’ and Q’B and Q”D on AC” respectively. Measures of X inefficiency simply take the excess of unnecessary cost as a percentage of actual cost. Thus:

Under All firms yield the same long run equilibrium outcome: price is equal to marginal cost and to average cost at its minimum. Production is efficient. Under perfect competition, there will in general be no x-inefficiency because inefficient firms can not survive in the long term.

Figure 10.3 Equilibrium of a Perfectly Competitive Firm.

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Under imperfect competition of any form firms have monopoly or market power. Monopoly power exists when a firm has control over the market’s outcome. As a result of monopoly power the firm will raise price, reduce quantity, retard innovation and discriminate among buyers. Monopoly power gives rise to a downward sloping demand curve, making the firm a price maker. If the firm is a pure monopolist, then the market and firm’s demand schedule will be identical. If the firm has less than 100% of the market, its demand curve will lie below or to the left of the market demand curve The two main indicators of monopoly power are market share and barriers to entry.

High market share: A firm’s market share is measured by its own sales, taken as a percentage of total sales in the market. A 10 % market share or lower usually gives the firm little market power. Between 10 and 100 % the degree of monopoly power rises as the share rises. A market share above 40% generally provides substantial monopoly power.

Barriers to entry : Any obstacle to entry will enhance the market power of the firms already established there. In the absence of entry barriers even a monopolist will have only limited market power.

The most important sources of market power are:

Mergers, Economies of scale, superior innovation or efficiency. Unfair competitive tactics such as predatory pricing, control of key inputs, and government policy towards patenting.

Presence of monopoly power distorts efficient allocation of resources. Allocative efficiency exists if price is equal to marginal cost for each product of each firm. Price will also equal minimum possible average cost in the long run. Allocative efficiency is guaranteed under perfect competition as shown in figure 10.3, in which long run equilibrium of the firm ensures that price is equal to marginal cost ( P = MC) and minimum of LAC is reached at equilibrium. On the other hand, under any form of market structure other than perfect competition, ( monopoly, monopolistic competition or oligopoly) , the equilibrium price is greater than marginal cost – P > MC as can be seen in figure 10.4. ( OP . e’XM. The presence of monopoly power thus distorts allocative efficiency.

Output is below the competitive level and Price is greater than marginal cost. However, with other market forms such as monopoly, oligopoly and monopolistic competition, it may be possible for x-inefficiency to persist, because the lack of competition makes it possible to use inefficient production techniques and still stay in business.

Figure 10.4 Equilibrium of an Imperfectly Competitive Firm

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Included in X- inefficiency are wasteful expenditures such as maintenance of excess capacity, luxurious executive benefits, political lobbying seeking protection and favourable regulations, and litigation.

Capacity utilization: Capacity utilization is closely related to the concept of efficiency. An firm utilizes the entire built incapacity. Unused capacity is referred to as excess capacity. Excess capacity is the characteristic feature under imperfect competition. Under imperfect competition the firms face downward sloping demand curve due the market power it enjoys that arises from differentiated products or entry barriers. As a result the point of equilibrium corresponds to falling portion of the LAC . The output of the firm is less than the competitive output, at which LAC is minimum. Even in the case of monopolistic competition, in which the firm earns only normal profit in the long run, in which entry barriers are absent, the equilibrium output is not at minimum LAC. Thus under any form of imperfect competition, there is excess capacity, as shown by XM XC in figure 10.4. PROFITS IN ACCOUNTING SENSE : The concept of profit to an accountant takes different interpretations. In an accounting sense, profit is the difference between turnover, or sales, and costs: that is,

Profit ( GROSS) = Turnover – Costs

Net Profit = Gross Profit – Expenses

Some of the basic concepts of profits used by accountants are: Profitability Ratios:A class of financial metrics that are used to assess a business's ability to generate  earnings as compared to its expenses and other relevant costs incurred during a specific period of time. For most of these ratios, having a higher value relative to a competitor's ratio or the same ratio from a previous period is indicative that the company is doing well. Some examples of profitability ratios are profit margin, return on assets and return on equity. Some industries experience seasonality in their operations. The retail industry, for example, typically experiences higher revenues and earnings for the Christmas season. Therefore, it would not be too useful to compare a retailer's 4th quarter profit margin with its 1st quarter profit margin. On the other hand, comparing a retailer's 4th quarter profit

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margin with the profit margin from the same period a year before would be far more informative.PROFIT MARGIN :

A profit margin tell us how much profit, on average, a business has earned per Rupee of turnover.

The gross profit margin ratio tells us the profit a business makes on its cost of sales, or cost of goods sold.

where turnover is sales.

Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit margin is displayed as a percentage; a 20% profit margin, for example, means the company has a net income of Rs 0.20 for each Rupee of sales.Looking at the earnings of a company often doesn't tell the entire story. Increased earnings are good, but an increase does not mean that the profit margin of a company is improving. For instance, if a company has costs that have increased at a greater rate than sales, it leads to a lower profit margin. This is an indication that costs need to be under better control.Imagine a company has a net income of Rs10 million from sales of Rs100 million, giving it a profit margin of 10% (Rs10 million/Rs100 million). If in the next year net income rose to Rs15 million on sales of Rs200 million, its profit margin would fall to 7.5%. So while the company increased its net income, it has done so with diminishing profit margins.

The net profit margin ratio tells us the amount of net profit per Rupee of turnover a business has earned. That is, after taking account of the cost of sales, the administration costs, the selling and distributions costs and all other costs, the net profit is the profit that is left, out of which the will pay interest, tax, dividends and so on.

OR

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When we compare the gross and the net profit margins we can gain a good impression of their non-production and non-direct costs such as administration, marketing and finance costs. The following example makes this clear .

Gross profit is the profit we earn before we take off any administration costs, selling costs and so on. So we should have a much higher gross profit margin than net profit margin. The gross profit margins vary from business to business and from industry to industry. For example, the international airline has a gross profit margin of only 5.62% yet the accounting software business has a gross profit margin of 89.55%. If a company's raw materials and factory wages go up a lot, the gross profit margin will go down unless the business increases its selling prices at the same time.

Just like the gross profit margins, the net profit margins also vary from business to business and from industry to industry. A comparison of the gross and the net profit margins gives information on their non-production and non-direct costs such as administration, marketing and finance costs.

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Table 10.1 Gross and Net Profit Margin – Example

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In the example, the international airline's gross profit margin is the lowest of this group of eight businesses at only 5.62%; but its net profit margin is 4.05%, only a little bit lower than its gross profit margin. On the other hand, the discount airline's gross profit margin is 27.46% but its net profit margin is a lot less than that at 10.87%. These comparisons give us a great insight into the cost structure of these businesses.

Look at the software business too, a very high gross profit margin of 89.55% but a net profit margin of 27.15%. This is still high, but this implies that the administration and similar expenses are very high whilst its cost of sales and operating costs are relatively very low.

After tax profit Margin A financial performance ratio, calculated by dividing net income after taxes by net sales. A company's after-tax profit margin is important because it tells investors the percentage of money a company actually earns per dollar of sales. This ratio is interpreted in the same way as profit margin - the after-tax profit margin is simply more stringent because it takes taxes into account.

Net Income Net income is a company's total earnings (or profit). Net income is calculated by taking revenues and adjusting for the cost of doing business, depreciation, interest, taxes and other expenses. This number is found on a company's income statement and is an important measure of how profitable the company is over a period of time. The measure is also used to calculate earnings per share. Often referred to as "the bottom line" since net income is listed at the bottom of the income statement.

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Return on Investment Capital A calculation used to assess a company's potential to be a quality investment by determining how well (i.e.. profitably) a company's management is able to allocate capital into its operations. Comparing a company's ROIC with its cost of capital reveals whether invested capital was used effectively.The general equation for ROIC is as follows:

Total capital includes long term debt, common and preferred shares. Since some companies receive income from other sources or have other conflicting items in their net income, net operating profit after tax (NOPAT) will be used instead.This is always calculated as a percentage. Invested capital can be in buildings, projects, machinery, other companies etc. One downside of ROIC is it tells nothing about where the return is being generated. For example, it does not specify if it is from continuing operations or from a one-time event, such as a gain from foreign currency transactions. Returns on Capital - ROCE Return on Capital Employed (ROCE) is used in finance as a measure of the returns that a company is realizing from its capital employed. The ratio can also be seen as representing the efficiency with which capital is being utilized to generate revenue. It is commonly used as a measure for comparing the performance between businesses and for assessing whether a business generates enough returns to pay for its cost of capital.

ROCE compares earnings with capital invested in the company. It is similar to Return on Assets, but takes into account sources of financing. In the denominator we have capital employed instead of total assets. In the numerator we have Pretax operating profit or EBIT.(Earnings Before Interest and Tax)

The main drawback of ROCE is that it measures return against the book value of assets in the business. As these are depreciated the ROCE will increase even though cash flow has remained the same. Thus, older businesses with depreciated assets will tend to have higher ROCE than newer, possibly better businesses. In addition, while cash flow is affected by inflation, the book value of assets is not. Consequently revenues increase with inflation while capital employed generally does not (as the book value of assets is not affected by inflation).Return on Equity: A measure of a corporation's profitability that reveals how much profit a company generates with the money shareholders have invested.  It is calculated as

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 Also known as "return on net worth (RONW)", the ROE is useful for comparing the profitability of a company to that of other firms in the same industry. There are several variations on the formula that investors may use:

1. Investors wishing to see the return on common equity may modify the formula above by subtracting preferred dividends from net income and subtracting preferred equity from shareholders' equity, giving the following:

ROCE = net income - preferred dividends / common equity.2. Return on equity may also be calculated by dividing net income by average

shareholders' equity. Average shareholders' equity is calculated by adding the shareholders' equity at the beginning of a period to the shareholders' equity at period's and dividing the result by two.

3. Investors may also calculate the change in ROE for a period by first using the shareholders' equity figure from the beginning of a period as a denominator to determine the beginning ROE. Then, the end-of-period shareholders' equity can be used as the denominator to determine the ending ROE. Calculating both beginning and ending ROEs allows an investor to determine the change in profitability over the period.

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ECONOMIES OF SCOPE

Economies of scope are cost advantages that result when firms provide a variety of products rather than specializing in the production or delivery of a single output. They are potential cost savings from joint production – even if the products are not related to one another. Economies of scope can arise from the sharing or joint utilization of inputs and lead to reductions in unit costs.

Figure 1. Economies of Scope

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As shown in Figure 1, the cost for an enterprise is cut in half if the resources are used in two enterprises rather than just one.  If the use of the resources is spread over three enterprises, the cost per enterprise is reduced to a third.

METHODS OF ACHIEVING ECONOMIES OF SCOPE

Flexible Manufacturing: The use of flexible processes and flexible manufacturing systems has resulted in economies of scope because these systems allow quick, low-cost switching of one product line to another. If a producer can manufacture multiple products with the same equipment and if the equipment allows the flexibility to change as market demands change, the manufacturer can add a variety of new products to their current line. The scope of products increases, offering a barrier to entry for new firms and a competitive synergy for the firm itself.

Related Diversification: Economies of scope often result from a related diversification strategy and may even be termed "economies of diversification." This strategy is operationalized when a firm builds upon or extends existing capabilities, resources, or areas of expertise for greater competitiveness. Firms select related diversification as their corporate-level strategy in an attempt to exploit economies of scope between their various business units. The cost-savings result when a business transfers expertise in one business to a new business. The businesses can share operational skills and know-how in manufacturing or even share plant facilities, equipment, or other existing assets. They may also share intangible assets like expertise or a corporate core competence. Such sharing of activities is common and is a way to maximize limited constraints.

Mergers: The merger wave in the world today is, in part, an attempt to create scope economies. Pharmaceutical companies frequently combine forces to share research and development expenses to bring new products to market. Pharmaceutical firms involved in drug discovery realize economies of scope by sustaining diverse portfolios of research projects that capture both internal and external knowledge spillovers.

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Linked supply chains: Today's linked supply chains among raw material suppliers, other vendors, manufacturers, wholesalers, distributors, retailers, and consumers often bring about economies of scope. Integrating a vertical supply chain results in productivity gains, waste reduction, and cost improvements. These improvements, which arise from the ability to eliminate costs by operating two or more businesses under same corporate umbrella, exist whenever it is less costly for two or more businesses to operate under centralized management than to function independently.

Cost savings opportunities can stem from interrelationships anywhere along businesses' value chain. As firms become linked in supply chains, particularly as part of the new E-economy, there is a growing potential for economies of scope. Scope economies can increase a firm's value and lead to increases in performance and higher returns to shareholders. The scope economies can also help a firm to reduce risks.

The factors causing economies of scope for a multi product firm are:

Cost complementarity Economies of initial capital requirement.

The cost advantages giving rise to economies of scope is expressed as:

Where S is the percentage cost reduction through joint production.CQ1 is the cost of producing good 1 if products are made separately; CQ2 is the cost of producing another different good. If we add these two we get the total cost of producing the two goods separately. But if they are produced jointly, the cost is C ( Q1 Q2 ). If there are economies of scope, C Q1+ C Q2 > C ( Q1Q2)

Economies of scope are not the same as economies of scale. Whereas economies of scale apply to efficiencies associated with increasing or decreasing the scale of production, economies of scope refer to efficiencies associated with increasing or decreasing the scope of marketing and distribution. Whereas economies of scale refer to changes in the output of a single product type, economies of scope refer to changes in the number of different types of products. Whereas economies of scale refer primarily to supply-side changes (such as level of production), economies of scope refer to demand-side changes (such as marketing and distribution). Because they frequently involve marketing and distribution efficiencies, economies of scope are more dependent upon demand than economies of scale. Economies of scope are one of the main reasons for such marketing strategies as product bundling, product lining, and family branding. However, economies of size and scope are not mutually exclusive.  While economies of scope allow costs to be spread over several products, the volume of each product can be increased to also achieve economies of size

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Economies of scope can help companies gain a significant competitive advantage. Not only do they trim expenses on a per-unit basis and improve profitability, but they can also force less cost-efficient competitors out of the industry or discourage would-be rivals from even entering the market.

Section A questions

1.Distinguish between substitutes and complements.

Goods that are substitutes satisfy the same set of goals or preferences. An example of a substitute for coffee is tea. If coffee prices are high, people are tempted to shift away from coffee to tea, and if coffee prices are low, people are tempted to shift from tea to coffee. Complements: A complement is a good that helps complete consumption of another good in some way. Complement goods are used together. The opposite of a substitute is a complement. The demand for complements move in the same direction. Ink is a complement to pen, and if pen is priced low enough, consumption of ink may rise. Car and petrol are complements. Sometimes goods are such good complements that they are sold together and we think of them as a single item. Left shoes and right shoes are an example.

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----------------------------------------------------------------------- 2.Bring out the relationship between slope of a demand curve and elasticity of demand. Elasticity and demand slope: The slope of a straight-line demand curve, one with a constant slope, has constantly change elasticity. No two points on a straight-line demand curve as the same elasticity. The point of intersection between the demand curve and the vertical, price axis is perfectly elastic (E = ∞). The intersection point between the demand curve and the horizontal, quantity axis is perfectly inelastic (E = 0). The exact middle, or midpoint, of the demand curve is unit elastic (E = 1). The segment between the midpoint and the price-axis intercept is relatively elastic (1 < E < ∞). The segment between the midpoint and the quantity axis intercept is relatively inelastic (0 < E < 1).It is observed that an elastic demand curve has low slope while an inelastic demand curve is steep and has a high slope. However slope depends on the scale we choose for both price and quantity.

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3.Write a note on : rectangular hyperbola demand curve.

A demand curve of constant elasticity of -1 will be a rectangular hyperbola. A rectangular hyperbola is a curve which joins all the  P: Qd points for which P x Qd (total sales revenues, or total consumer spending) is constant. Thus all rectangles under the demand curve have the same area ( P.Q). Such a unitary elastic demand curve is asymptotic, ie, it approaches the axis but will never touch it.

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_____________________________________________4.Distinguish between fixed cost and variable cost. Total cost can be divided into two portions: Fixed Cost and variable cost.Fixed cost is the part of the budget that stays the same regardless of production level, even if production is zero. Overhead, rent on buildings, and interest on loans are in fixed cost. Variable Cost is the rest of total cost, the part that varies with production level. Producing more adds to Variable Cost. Producing less reduces it. Thus variable cost is a function of output. Expenditure on raw material and labour employed is variable cost.

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5.Show that the average fixed cost curve is a rectangular hyperbola.

AFC = TFC/q, where TFC is constant. Since total fixed costs are constant , as output increases, fixed costs per unit of output decline—a process that many managers describe as “spreading overhead” through high volume. If we arbitrarily select any two points on the AFC curve (say, a and b), the rectangles formed by dropping horizontal and vertical lines to the axes have identical areas. Since AFC = TFC/q, multiplication of AFC by q yields TFC - ( TFC/q x q = TFC, which is constant.) Thus, the AFC curve is a rectangular hyperbola and they resemble unitarily elastic demand curves, which are also rectangular hyperbolas.

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6.Why is SAC ‘U’ shaped? The short run average cost curve is u shaped because of the Law of Variable Proportions, which is the short run production function. In the short run since quantity of some factors such as machines , ( capital) can not be increased, the variable factor does not get adequate capital to work with as output increases. As a result initially when capital is in surplus, that is proportion of capital to labour is high, the marginal product and average product of the variable input ( labour) increases ( TP of the variable input increases at increasing rate ), and subsequently as the proportion of capital to labour becomes less and less, the marginal product and average product of starts decreasing ( TPL increases at decresing rate) and eventually MPL may even become negative if production continues beyond the point where TPL is maximum. Correspondingly, when AP increases the SAC initially decreases, reaches a minimum ( where APL is maximum) and after reaching minimum starts increasing, as APL starts decreasing. Thus the U shape of SAC may be attributed to Law of Variable Proportions. This is illustrated below.

________________________________________________________

7.What are economies of scale?

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When more units of a good or a service can be produced on a larger scale, yet with (on average) less input costs, economies of scale (ES) are said to be achieved. Alternatively, this means that as a company grows and production units increase, a company will have a better chance to decrease its costs. Thus economies of scale are reductions in cost enjoyed by the firm as it expands its output either because of its own action or because of an action or decision external to the firm.Adam Smith identified the division of labor and specialization as the two key means to achieve a larger return on production. Through these two techniques, employees would not only be able to concentrate on a specific task, but with time, improve the skills necessary to perform their jobs. The tasks could then be performed better and faster. Hence, through such efficiency, time and money could be saved while production level increased. The downward sloping portion of Lac is because of the strong economies of scale.

8. Distinguish between internal and external economies of scaleAlfred Marshall made a distinction between internal and external economies of scale. When the increase in production of a firm reduces its cost internal economies of scale have been achieved. External economies of scale occur outside of a firm, within an industry. Thus, when an industry's scope of operations expands due to, for example, the creation of a better transportation network, resulting in a subsequent decrease in cost for the firm working within that industry, external economies of scale are said to have been achieved. With external economies , all firms within the industry will benefit.

9. How are economies different from diseconomiesEconomies of scale are reductions in cost enjoyed by the firm as it expands its output either because of its own action or because of an action or decision external to the firm. Division of labor and specialization as the two key means to achieve a larger return on production.Diseconomies stem from inefficient managerial or labor policies, over-hiring or deteriorating transportation networks (external DS). Furthermore, as a firm’s scope increases, it may have to distribute its goods and services in progressively more dispersed areas. This can actually increase average costs resulting in diseconomies of scale. Thus economies reduce cost for the firm as it expands while diseconomies increase cost for the firm as production is increased.

10.The wages paid to workers – is it a fixed cost or variable cost. Account for your answer.The wages paid to workers is variable cost since it varies with output. An expansion in output requires more labour and hence the wage bill component of the total cost will increase with increase in output.Hence wages paid to labour is a variable cost

11.The expenditure on maintenance of machines and equipments – fixed or variable cost. Explain. The expenditure on maintenance of machines and equipments is a fixed cost. Fixed costs such as expenditure on maintenance of machines and equipments is an expenditure incurred per time period and do not change with output and must be incurred even if the output level is zero.

12.What are the components of fixed cost? Components of fixed cost are:

salaries of administrative staff depreciation ( wear and tear ) of machinery expenses for building depreciation and repairs expenses for land maintenance and depreciation.

13.What is excess capacity.

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Excess capacity is the unutilized capacity in the plant corresponding to equilibrium output. It is the difference between the output corresponding to minimum cost ( more often referred to as the competitive output) and the equilibrium output. Excess capacity exists under imperfect competition since firms under imperfect competition have a downward sloping demand curve depicting their monopoly power. Excess capacity is undesirable because it leads to higher unit

cost.

14. Can a firm under monopolistic competition make super normal profits in the long run. Firms under monopolistic competition can make only normal profit, in spite of a downward sloping demand curve because of the condition of free entry and exit. As a result any excess profit that arises due to differentiated products or advertisements or due to price reductions will be wiped out by the entry of new firms. The long run equilibrium for a firm under monopolistic competition is illustrated below:

15.How is monopolistic competition different from perfect competition Monopolistic competition is different from perfect competition on following grounds:Monopolistic competition is characterised by large number of firms but not as large as under perfect competition.Under monopolistic competition the firm is a price maker and it indulges in price competition

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A firm under monopolistic competition indulges in non price competition through product differentiation and selling costs which gives some monopoly power to the firms. As a result the firm’s demand curve is not perfectly elastic as under perfect competition but downward sloping and fairly elastic.A perfectly competitive firm earns only normal profit in the long run because of free entry conditions and the long run equilibrium ensures productive and allocative efficiency. That is, corresponding to long run equilibrium, P = MC, and LAC is at its minimum as shown in the figure.A firm under monopolistic competition also makes only normal profit in the long run like a competitive firm but the normal profit comes with excess capacity. Due the downward sloping AR curve, there is unused capacity in the plant at equilibrium and P > MC. Thus the firm at equilibrium is characterised by both productive and allocative inefficiency, as shown in the figure.

16.Distinguish between monopoly and monopsony. Give examples.

Monopoly is characterized by single seller where as monopsony is characterized by single buyer.Indian railways is an example of monopoly where as Integrated coach factory that used to be the exclusive supplier of coaches to Indian railways was a good example of monopsony until some years back.

17.What are economies of scope. Economies of scope are changes in average costs because of changes in the mix of output between two or more products. This refers to potential cost savings from joint production even if the products are not directly related to each other. For example a company’s management structure , administrative systems and marketing departments are capable of carrying out these functions for more than one product. Warehouse facilities may be used to maximum advantage by storing a range of the company’s product lines. Often, as the number of products promoted is increased and broader media used, more people can be reached with each rupee spent. This is one example of economies of scope. . In the publishing industry there might be substantial cost savings from using a team of journalists produce more than one magazineExample: The Hindu group of publications producing Business Line, Front Line, the Survey of Industries and the Survey of Environment. etc apart from The Hindu. Economies of scope occur when there are potential cost savings from by products in the production process.

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18. Distinguish between economies of scale and economies of scope Economies of scope are changes in average costs because of changes in the mix of output between two or more products while economies of scale are change in average cost due to changes in scale of output. Economies of scale refers to the notion of increasing efficiencies of the production of goods as the volume of output increases. Economies of scope are similar to Economies of scale. Whereas economies of scale refer to changes in the output of a single product type, economies of scope refer to changes in the number of different types of products. Whereas economies of scale apply to efficiencies associated with increasing or decreasing the scale of production, economies of scope refer to efficiencies associated with increasing or deceasing the scope of marketing and distribution.. Economies of scale refer primarily to supply-side changes (such as level of production), but economies of scope refer to demand-side changes (such as marketing and distribution). Economies of scope are one of the main reasons for such marketing strategies as product bundling, product lining, and family branding. 19. What is product differentiation.Products are differentiated when the products of different firms are not perfect substitutes -- instead, "every firm has a monopoly of its own product." Nevertheless, firms may compete by changing the characteristics of the product they sell. The idea is not necessarily to make a better product than the competitor, just different -- to appeal to a different "market niche."

It increases variety, thus increasing the range of consumer choice. It divides up the market, leading to higher prices and costs

Product differentiation is a salient feature of imperfect competition , particularly monopolistic competition. Product differentiation is intended to distinguish product of one firm from that of other firms in the industry. It creates brand loyalty of the consumer and gives rise to a downward sloping demand curve.20 How does product differentiation influence concentration.Product differentiation increases concentration by acting as an entry barrier. In markets where product differentiation is intense, entry barriers are strengthened and hence the entry preventing price PL will be closer to the profit maximizing price. Product differentiation gives monopoly power to the firm and increases concentration.21.Will advertisement for a firm’s product increase concentration of firms in the market. Advertising expenses are basically expenses incurred to alter the shape and position of the demand curve. More specifically they make the demand curve for the firm’s product more inelastic and shifts it upward by altering peoples preferences in favour of the firm’s product. As a result it acts as an entry barrier and enables the firm to increase its limit price, closer to monopoly profit maximizing price and yet prevent entry. Thus advertisement increase concentration .22. What can you infer about market concentration from elasticity of demand?In a concentrated market elasticity of demand is low or demand is relatively less elastic. On the other hand , in a market with fairly elastic demand concentration is low. Monopoly is the example of extremely high concentration while perfect competition, in which firms have with perfectly elastic demand curve, is best example of zero or low concentration with high elasticity. Oligopoly wit fewer firms and greater concentration had relatively

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inelastic demand curve. Monopolistic competition with relatively elastic demand curve for the firm, has low concentration.23.What are contestable markets.?A contestable market is a market with low barriers to entry, and a perfectly contestable market requires a total absence of barriers to entry. If super-normal profits are earned potential competitors may enter the market, so it is argued that the existing firm(s) will keep prices and output at a level where only normal profits are made. In some cases potential competitors may engage in hit-and-run behaviour. A hit-and-run competitor will notice when super-normal profit is being made, enter the market and take advantage of the situation. As prices settle down once more the hit-and-run competitor exits the market again. Thus the incumbent firms become wary of the potential competitor and set prices so that hit-and-run competitors are discouraged. For hit-and-run competition to be a threat, not only must the costs of entry to the market be low, the costs of exit need to be low too. The costs of exit are sometimes called ‘sunk costs’. These are costs that cannot be recovered when the firm leaves the market. Thus a contestable market requires both low entry and exit barriers.

UNIT 324. Define selling costsSelling costs are costs incurred to alter the shape and position of the demand curve. These are undertaken by the firm to create brand loyalty and to make the product unique in the mind of the consumer. They are additions to production cost incurred to persuade the consumer and to change the preferences of the consumer towards the product that is promoted. Selling costs serve as barrier to entry for the incumbent firms.25. Barriers to entry are those factors that allow incumbent firms to earn positive economic profits, while making it unprofitable for newcomers to enter in to the industry. Barriers to entry may be structural or strategic. Structural entry barriers result when the incumbent has natural cost or marketing advantages or benefits from favourable regulations. Strategic entry barriers result when the incumbent aggressively prevents entry. Such entry deterring strategies include limit pricing, predatory pricing and capacity expansion. 26.Collusive oligopoly --A market situation in which the sellers have entered into express agreements on price and output, i.e., a cartel. In general, the smaller the number of firms in a market (and the larger their respective market shares), the less their need to use actual collusion as a coordinating device; "oligopolistic interdependence" is frequently sufficient in the tight-knit oligopolies. (See Oligopoly.) In the looser oligopolies, however, the larger number of firms and their smaller individual market shares greatly weakens that sense of interdependence and hence increases the difficulty of maintaining coordinated prices except through the cartel apparatus of agreements, sanctions, and so forth. .27. Concentration—Concentration is the combined market share of the leading firms or oligopolists .It is the number and size distribution of the firms in an industry or market, most commonly expressed in terms of a "concentration ratio," i.e., the percentage of production or sales accounted for by some relatively small number of firms, generally the "four largest" and the "eight largest." The competitive significance of these ratios is said to lie in the proposition that they are correlated with price levels--the higher the concentration ratio, the further the price is expected to rise above the competitive floor and

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toward the monopoly ceiling. In substance, as the number of firms decline and the size of their respective shares increases, the incentive to engage in price competition is lessened and their incentive (and capacity) to collude, either expressly or tacitly, is increased. 28. Monopsony--A market with only a single buyer, the buying-side counterpart of Monopoly (a single firm on the selling side). Just as the monopolist finds it profitable to restrict output below the competitive level in order to raise the price, the monopsonist finds it profitable to restrict its purchases--to buy fewer units than would have been purchased by a group of competing buyers under similar conditions--and thereby depress the price it has to pay below the competitive level, i.e., below that which a group of competing buyers would have offered.29. Limit pricing: Limit pricing refers to the practice whereby an incumbent firm discourages entry by charging a low price lower so that in the post entry period the price would not cover the cost of the entrant and thus make entry unprofitable for the entrant. Thus limit price will dissuade the entrant from entering the industry. Limit price is given as :

PL = PC ( 1+ E ) Where E is the condition of entryE can be expressed as PL – PC E = ---------- PC

30.Predatory pricing refers to the practice of setting a low price in order to drive other firms out of business. The predatory firm expects that whatever losses it incurs while driving competitors from the market can be made up later through the exercise of market power. The predatory firm first lowers its price until it is below the average cost of its competitors. The competitors must then lower their prices below average cost, thereby losing money on each unit sold. If they fail to cut their prices, they will lose virtually all of their market share; if they do cut their prices, they will eventually go bankrupt. After the competition has been forced out of the market, the predatory firm raises its price, compensating itself for the money it lost while it was engaged in predatory pricing, and earns monopoly profits forever after. The difference between predatory pricing and limit pricing is that limit pricing is directed at firms that have not at entered the market ( potential entrant) where as predatory pricing is aimed at firms that are already in the market. In the late nineteenth century, Standard Oil's allegedly predatory price cutting ,drove out the Pure Oil Company, from the petroleum-refining business.31.Discriminatory pricing refers to the charging of different prices for different quantities of a commodity or in different markets which are not justified by cost differences. By practicing price discrimination the monopolist can increase its total revenue and profits. Price discrimination is practiced by the monopolist when the demand for the commodity in the different markets is not isoelastic, that is , elasticity of demand for the differs in different parts of the market. 32. Elasticity of demand and price discrimination : An important condition for price discrimination is that the demand for the commodity in the different segments of the

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markets should not be isoelastic. The monopolist will charge a high price in the market where demand is relatively inelastic and a lower price in the market with relatively elastic demand. 33. PL, PC, PM - ComparisonLimit price, PL, is the price that deters entry. It is normally lower than profit maximizing price and higher than competitive price depending on ht strength of the barriers. If barriers are strong the limit price PL is closer or in the extreme case equal to profit maximizing price. If entry barriers are weak the limit price may equal competitive price. Competitive price is equal to marginal cost and monopoly profit maximizing price is given by MC = MR condition and is greater than MC. The three are shown in the following diagram that is drawn on the assumption of constant cost conditions so that AC = MC .

The limit price PL shown in figure will move toward PM if barriers to enter are strong and will move towards PC if barriers to enter the industry are weak.

34. Relation ship between limit price and entry barrierLimit price PL is defined as :PL = PC ( 1+ E ) , where E is the condition of entry.When entry barriers such as product differentiation and advertisements are high , limit price PL will be high and closer to profit maximising price PM and entry barriers are weak, PL will be low and closer to competitive price. Thus strong barriers result in high limit price and weak barriers result in low limit price.

Unit 4 – Mergers35.Which kind of merger always increases market power?Horizontal mergers invariably increases market power, since by definition they eliminate side by side competition between two firms. The effect may be small or large depending on the two firms market share and on other conditions of market. Horizontal merger occurs between companies producing similar goods or offering similar services and hence increases market power and market concentration. This type of merger occurs frequently as a result of larger companies attempting to create more efficient economies of scale. The amalgamation of Ponds and Hindustan Lever is a popular example of a horizontal merger. 36.The main goals of the merger are:

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increased market share profit maximisation improving efficiency risk spreading

These goals can be reached by internal growth and long term contracts.37. Reasons for the break of merger1.Not having clear goals and plans to achieve them2.Skimping on the merger integration budget. Companies often think they can save by cutting costs on the merger integration process. This is not the place to skimp. Management often miscalculates the length of time the merger will take, and the complexity of the merger.3.Moving too slowly. Allowing things to settle down before making changes is dangerous. Moving too slowly increases the uncertainty and anxiety felt by employees. Many companies believe they can conduct business as usual while they figure out the best course to take with the merged companies. This is a big mistake because once employees and customers smell the scent of a merger, business is never the same.4.Not clearly defining roles, responsibilities, and working relationships. People are worried about their short-term and long-term futures. Without clear responsibilities and lines of authority, workers go into idle mode as they wait and see what happens. They hesitate when making decisions because they do not understand the rules for making decisions, the rewards for making correct decisions, and the penalties for making mistakes. 38.Mergers in Indian business scenario:In India since the 1970s both MRTP and non-MRTP companies have used mergers and take-overs as an important means of growth. Second, there was acceleration in the merger movement in the liberalisation years of the 1990s. The total number of amalgamations during the period 1975-76 to 1979-80 was 156. The figure remained at 156 during 1980-81to 1984-85, and then fell to 113 during the period 1985-86 to 1989-90. However, facilitated by changes in the policy environment, the number of mergers rose sharply to 236 during the period 1990-91 to 1994-95. The participation of manufacturing firms in the merger movement was always higher than that of the non manufacturing firms However, the participation of non-manufacturing firms in the amalgamation trend increased sharply in the 1990s. the average number of non manufacturing firms resorting to mergers during the period 1990-94 had touched 22, which was not far below the 25 recorded in the case of manufacturing firms. One reason for this was the financial liberalisation of the 1990s which increased mergers with a dormant finance companies to facilitate early listing in the stock market which allowed the private limited companies to exploit the capital market boom through the private placement of shares.

Unit 5 39. Indicators of performance:The main indicators of performance are:Efficiency – referring to maximum value of output for given values of input. His is productive efficiency.Efficiency also includes allocative efficiency which requires that at equilibrium, P = Marginal cost.

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Profit: Profit is the difference between turnover, or sales, and costs. There are several ways of measuring profit: gross profit; net profit before and after taxation; and retained profit are just some of them

Gross profit margin is :

Gross Profit Margin

=Gross Profit

* 100Turnover

The gross profit margin ratio tells us the profit a business makes on its cost of sales, or cost of goods sold. It is a very simple idea and it tells us how much gross profit per Re1 of turnover our business is earning. Gross profit is the profit firms earn before deducting any administration costs, selling costs and so on. G Hence gross profits are higher than net profit margin.

Net Profit = Gross Profit – Expenses

Net Profit Margin =Net Profit

* 100Turnover

The net profit margin ratio tells us the amount of net profit per Re of turnover a business has earned. That is, after taking account of the cost of sales, the administration costs, the selling and distributions costs and all other costs, the net profit is the profit that is left, out of which firms will pay interest, tax, dividends and so on.

40. Can competition optimize the conservation of resources?

Perfect competition ensures optimum allocation of resources and least cost production when all firms are in long run equilibrium. The features of perfect competition .particularly the features of large number of buyers and sellers, homogeneous products and fee entry and exit conditions make the firm a price taker. Hence the demand curve of the firm is perfectly elastic at the given price level. Free entry conditions wipe out all the short period profits. In the long run at equilibrium , not only is the firm’s MC = MR, the condition necessary for profit maximization, but P is also equal to MC and LAC is at its minimum at equilibrium. The equality of P to MC indicated allocative efficiency and minimisation of cost indicates productive efficiency. Plant is fully utilizes and there is no unused capacity in the plant. There is no X inefficiency. The fulfillment of productive

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and allocative efficiency indicate that optimum conservation of resources. The following

figure illustrates this condition:

41. Will monopoly illustrates this condition distort optimum allocation of resources

Monopoly distorts optimum allocation of resources because under monopoly the firm ( industry) is a price maker and given closed entry conditions the monopolists exploits the consumers by charging high price and restricts output. The price charged by the monopolist is greater than marginal cost indicating allocative inefficiency and the equilibrium of the monopolist corresponds to falling portion of the AR ( Dd) curve. Thus there is productive inefficiency and the output is less than competitive output. This implies that there is excess capacity under monopoly. The productive and allocative inefficiencies resulting in distortion of optimal results is shown below:

42. What is monopoly burden

Monopoly charges a price that is greater than marginal cost and hence there is a dead weight loss under monopoly. Under perfect competition P = MC and hence aggregate social welfare measured by consumer surplus and producer surplus is maximized. This dead weight of monopoly is illustrated below. The assumption of constant cost conditions

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gives rise to a long run supply curve that is a horizontal straight line. If this line is treated as the competitive supply curve, long run competitive equilibrium is at EC with an output XC price PC = LMC. Consumer surplus is equal to the triangle DPCEC and producer surplus is zero. The same diagram can be used to show the position of the monopolist, considering the LRS of the competitive firm as the LMC. The monopolist will set a price and output using the MC = MR condition. He will produce QMamount of output and charge PM

price .His consumers surplus is the area DAPM and producer surplus is the area PM ABPC.

Comparing this with perfect competition , there is a dead weight loss under monopoly equal to the area ABEC. Therefore the monopoly of the firm under monopoly creates greater producer surplus and lower consumer surplus in comparison to perfect competition which is termed as dead weight loss or monopoly burden.

43. Allocative efficiency and X efficiency

Allocative efficiency occurs when output is at the level where marginal cost is equal to price in each product of each firm throughout the economy. X-efficiency is the effectiveness with which a given set of inputs are used to produce outputs. If a firm is producing the maximum output it can, given the resources it employs, such as men and machinery, and the best technology available, it is said to be x-efficient. X-inefficiency, on the other hand, is the difference between efficient behavior of firms assumed or implied by economic theory and their observed behavior in practice. In perfect competition, the free entry and exit of firms enable firms to produce at the point where price equals long run average costs and long run average costs are minimized. Thus firms earn zero economic profits and consumers pay a price equal to the marginal cost of producing the good. This result defines economic efficiency or, more precisely, allocative

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economic efficiency. Perfect competiton satisfies Xefficiency too. X-efficiency is also known as technical efficiency.

In a market with perfect competition, there will in general be no X-inefficiency because if any firm is less efficient than the others it will not make sufficient profits to stay in business in the long term. However, with other market forms such as monopoly it may be possible for x-inefficiency to persist, because the lack of competition makes it possible to use inefficient production techniques and still stay in business.

44. State the factors giving rise to in efficiency in production

Some of the important factors giving rise to inefficiency in production are:

lack of competition obsolete production technology

product differentiation and advertisemen that increase cost that resultin a downward sloping demand curve.

Strong entry and exit barriers

45. Which market structure is favourable for invention? Why?The inventive effort will normally be optimised by competitiors. Effective competition – from atomistic to loose oligopoly structure tends to opitmise both invention and innovation. It also passes on the benenfits to consumers.Monopolists, by contrast, tend to invent and innovate below optimum levels.They also retain much of the value of progress in their excess profits. Therefore the monopolist will apply a restrictive policy to inventions seeking and using them less fully than would occur under competition. Similarly a monopolist believes that a new innovation will destry some or all th evalueof its existing technology.For example, satellite communication can make telephone cables worthless. Hence a monopolist always will bring in new processes and products at below the social optimal rate and competitiors will innovate more fully than mnopolist.46.Is R & D to be maximised or optimised?R &D is to be optimised because it is an input.It is to be minimised for any given level of yield.Opimum R & D is given by the equlity of marginal cost of R & D to marginal rate of return from R & D’ as shownin the following figure:

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47.Two industries with high degree of technological opportunity : Electricals and electronics, automobile industry etc. Two industries with low degree of technological opportunity : Paper industry,

48.Competition optimises innovation while monopoly optimises innovation – This is not a valid statement since both invention and innovation are optimised only under competition and monopoly tends to restrict them.. Effective competition – from atomistic to loose oligopoly structure tends to opitmise both invention and innovation. It also passes on the benenfits to consumers.Monopolists, by contrast, tend to invent and innovate below optimum levels.They also retain much of the value of progress in their excess profits. Therefore the monopolist will apply a restrictive policy to inventions seeking and using them less fully than would occur under competition. Similarly a monopolist believes that a new innovation will destry some or all th evalueof its existing technology.For example, satellite communication can make telephone cables worthless. Hence a monopolist always will bring in new processes and products at below the social optimal rate and competitiors will innovate more fully than mnopolist.

49 Normal profit denotes the minimum return required to induce an individual or a firm to invest in a particular productive activity. Normal profits are in effect the minimum required return to capital in risky ventures, they are treated by economists as being essentially costs of production and are therefore included in the cost functions of the firm. A firm is said to be earning normal profits when its average cost is equal to its average revenue. If we define profits as Π = R – C , then normal profits are included in the term C. In the figure, at the equilibrium point e , the firm’s AC is tangent to AR and hence the firm is making only normal profits. The symbol denotes any profit the firm earns over this normal amount, and so is called super normal profit. Normal profits for a competitive firm and super normal profit for an imperfectly competitive firm are shown below.

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50. Firms under perfect competition and monopolistic competition can make only normal profits in the long run as shown below:

 

A firm under any form of imperfect competition except monopolistic competition can earn super normal profits both in the short run and long run. as shown below:

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51.Market concentration and profits:Profits are higher in markets that are concentrated such as oligoploy and monopoly. Firms in such markets can enjoy super normal profits in both short run and long run.Firms in markets such as perfect competition and monopolistic competition which are not concentrated do not earn super normal profits in ht elong run because of absence of entry barriers.however th efirms in such markets will earn super normal profit in the short run. In general, in highly concentrated markets profits are higher than in markets where concentration is insignificant.

52.Will barriers to entry affect profits: Barriers to enter a market will increase the profits of an incumbent firm. Barriers to entry will increase concentration and market share and thus enhance profits of a existing firm. The various barriers are :Product differentiation ,advertisement ,absolute cost advantage barrier ,high initital capital requirement barrierIn the presence of such barriers the limit proce of the firm will be closer to or equal to profit maximising price and the firms will earn higher profits than in the absence of such barriers. When these barriers are weak the firm will have to charge a price as low as competiitve priceand forego market as well as profits in the post entry period. The figure below shows the limit price the firms can charge under different strengths of barriers . A higher limit price gives the firm higher profit and a lower limit price reduces the profit to normal profit level.

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