IndustryIndustryParadigmsParadigms

Market Structure Impacts the Price

Clearly, Market Structure Will Impact Industry Pricing.

But, What Other Factors Might Impact How Pricing is

Determined within an Industry?

Structure-Conduct-Performance

(SCP) Paradigm

X-Efficiency TheoryHarvey Leibenstein (1966) originated X-inefficiency as a concept to cover non-allocative inefficiencies in an organization. X-inefficiency was a counterpart to technical inefficiency and was to capture organizational or motivational inefficiency.

X-Efficiency Theory Based on:

(1) Relaxing Maximizing Behavior Assumption: Assumes that some forms of decision making, such as, habits, conventions, moral imperatives, standard procedures, or emulation, can be and frequently are non-maximizing. Incorporates the Yerkes-Dodson Law, which states that at low pressure levels individuals will not put much effort into carefully calculating their decisions, but as pressure builds they move toward more maximizing behavior.

(2) Inertia Assumption: Assumes that some changes in “independent variables” do not affect “dependent variables,”because of organizational inertia or blocking.

(3) Incomplete Contracts: Assumes employment contracts specify payment or compensation, but do not completely specify “effort side.”

(4) Discretion: Assumes employees and management each have discretion with respect to working conditions and some aspects of wages.

Under these assumptions, the firm does not control all the variables. The variables are controlled by employees on the one side, and management on the other; both jointly determine outcome (profits, prices, production, etc.).

An Example of X-Inefficiency

Leibenstein offers this example of X-inefficiency as cited in the New York Times (October 1981) that compared two identically designed Ford plants, one in the UK and the other in Germany and both designed to produce the identical automobile with the same manpower and equipment. Nonetheless, the German factory produced 50% more automobiles than its UK counterpart with 22% less labor.

Why? Leibenstein argued it was a different level of “effort” due to local “conventions.”

X-efficiency Theory Conclusions

Leibenstein summarized his theory as follows:

Firms generally operate within rather than on their production frontiers. As such, their output is not maximized and their costs per unit are generally not minimized. Innovations are generally not introduced when it is optimal to do so. Less output is not necessarily associated with more desired leisure. The price of the product can have an influence on the cost of production.

Another Paradigm for Industry Analysis

Contestable Markets Theory (CMT)

The CMT (Baumol, Panzar & Willig, Contestable Markets and the Theory of Industry Structure, 1982 and Baumol, “Contestable Markets: An Uprising in the Theory of Industry Structure.” American Economic Review, March 1982, pp. 1-15.) was developed to explain why industry structures ranging from perfect competition to oligopoly to monopoly may be optimal. Optimality in CMT does not depend on the number of competitors.

SCP model is based on the actions or assumed motivations of the existing firms, while CMT focuses upon the pressure of potential competition and its effects on the existing firms.

The CMT basis is that no industry can earn economic profits for an extended period unless other potential sellers, willing to charge lower prices, are blocked from entering the industry when existing firms offer their product at a price that is too low to allow for profitable underpricing.

• A contestable market occurs when “entry is absolutely free, and exit is absolutely costless.” (Baumol, 1982)

• There are no sunk costs and any fixed costs are recoverable on exit from an industry.

• New market entrants enjoy the same cost structure as existing firms because they have access to the same technology and efficiency levels.

Entry to market as a market discipline goes back to at least John Bates Clark (1912) and

updated by Bain (1956).

Industry Forces Acting on Profits

Porter’s Force I: Intensity of Competition

1. Total industry profits are greater with coordination than without.

2. When price is above marginal cost, it is in the interest of a firm to lower its price a little to increase market share and increase its own profits. But collectively, if ever firm did that then the above-marginal cost pricing will be threatened.

Intensity of Competition:Number of Competitors

• Large numbers of firms reduce market coordination within an industry and reduce excess profits.

• How do you measure the firm power? Industry concentration ratios are used, which are generally calculated as the percent of the total industry sales or employment accounted for by the largest four firms in that industry.

Intensity of Competition:The Size Distribution of Market

Participants

1. In general, industries that have firms of similar size, rivilary is more intense. An example: European automobile market -- seven auto markers with 10~15% individual market share.

2. A measure of industry “balance” or distribution is the Herfindahl Index (HI), which often used by the government to evaluate the impact of mergers.

Herfindahl Index (HI)

Where S is the market share of the ith industry.

For example, given an industry with the following market share by firm:

Firm 1: 0.5Firm 2: 0.25Firm 3: 0.25

HI = 10,000*(0.52 + 0.252 + 0.252 ) = 3750

HI can range between 0 and 10,000.

Herfindahl Index (HI)

When the HI exceeds 1,800 the industry is more concentrated and less rivalry exists. Firms in the same industry attempting to merge generally will be challenged by the Justice Department when the HI will exceed 1800.

Porter’s Force II: Substitute Products

Porter’s Force III: Buyer Power

For example, fast-food chains (McDonald’s or Burger King) command considerable power over

Coca-Cola and Pepsi.

Porter’s Force IV: Supplier Power

Porter’s Force V: Entry & Exit from Industry

Economies of Scale and Minimum Efficient Scale

Excess Capacity

Legal Constraints (Licenses and Patents)

Industry Profile

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A Typical Progression in Industry Development

Entry

Take-off

Maturity

Minimum Efficiency for

Industries Given

Product Demand

How much of the market must a firm control to be efficient?

Some Empirical Observations

Theory would suggest that the marginal cost curve is

sloping in which direction?

Marginal Cost Curves: Survey of U.S. Industry

Source: Blinder, Cannetti, Lebow & Rudd, Asking About Prices.

Survey data suggests that about 90% of all firms have downward or flat Marginal Cost curves.

WHY?

Is the flat or downward

sloping marginal cost curves due to

faster diffusion of technology,

which appears as a declining

or flat marginal cost?

How Long Does it Normally Take Before a Price Change Occurs Once the Cost-Side Changes?

Now that we have sampled the paradigms, let’s turn our

attention to modeling . . .