Market Structure I:Perfect, Ricardian, and Williamsonian markets

Paul C. Godfrey

Mark H. Hansen

Marriott School of Management

Why do these topics matter to strategists

• Perfect markets almost never occur, but form a strong analytical base case from which to draw comparisons

• Ricardian markets have a lot of real world features, and implications for formulating strategy

• Williamsons views of markets help managers make crucial decisions about vertical integration, diversification, and alliances

• Markets with externalities change the decision calculus

Perfectly competitive markets

Perfect competition: Assumptions

Product markets

• Differing tastes/ preferences/ needs

• Identical products

• Price-taking consumers

• Full information

• No uncertainty

• No externalities

Factor markets

• All assets completely tradable: identical products

• Price-taking sellers

• No scale economies

• Costless entry/ exit

• Full information

• No externalities

P P

Q Q

Dind

Sind

Pind

Qind

Pind = Pff

Qff

MCff

ACff

D=MR

Market Equilibrium Firm Equilibrium

Determining Equilibrium Price and QuantityIndustry vs. Firm

P

Q

Pind1

Qff

MCff

ACff

D=MR

P

Q

Pind2

Qind

MCind

ACind

D=MR

Determining Equilibrium Price and QuantityMarket Adjustment

• Market clears– No excess demand

• No economic profit– All sellers have same cost

curve– Entry/ exit stabilize price

• Industry supply schedule is flat

• Productive efficiency– All production most cost

efficient

$

Quantity

MCind

P

ACind

Industry supply curve

Determining Equilibrium Price and QuantityIndustry Costs and Supply

Perfect competition: Social results

• A market that clears leads to allocative efficiency

– All consumers, producers satisfied– Only consumers get surplus

• Productive efficiency– All production occurs at minimum

cost

• Pareto optimal– No one better off without someone

else worse off– All mutually beneficial trades

executed

$

Quantity

D0

P*

ConsumerSurplus Industry supply curve

Ricardian markets

The basics

• David Ricardo (1772-1823)

• Considers corn (grain) production in the British economy

• All assumptions the same as perfect competition except,

• Plots of land are of various quality for producing corn– Variations in quality inhere in the land (non-tradable or fungible)

– Differential quality is a fixed attribute

– Each plot of land requires the same amount of labor to work (marginal costs are equal)

A Ricardian corn market• Economic rent = the difference

between the market return of a piece of land and the return of the marginal plot in production

• Farms (firms) earn rents on unique, valuable, and rare assets.

• The most valuable farm (firm) will have the lowest average cost per unit of corn

Corn output/$

Units in production

Oc

Oc—the opportunity cost of putting the land to the plowMarginal plot of land

Rent

Ricardian markets: Social results

• A market that clears leads to allocative efficiency

– All consumers, producers satisfied– Consumers and producers get

surpluses

• Productive efficiency– All production occurs at minimum

cost (over total output)

• Pareto optimal– No one better off without someone

else worse off– All mutually beneficial trades

executed

$

Quantity

D0

P*

ConsumerSurplus

S0

Producer Surplus

Managing in (for) a Ricardian market

• Firms that can capture, create resources can earn rents– resources can heterogeneously distributed (rare) and immobile (costly

to imitate)

• Resources can be endowed, as in nature

• Resources can be developed through investment

– this is a critical point to the strategist!

Resources can be managed!

Williamsonian Markets: The role of transaction costs

Transaction costs

• In perfect markets there are no transaction costs, or costs (risks) of doing the deal

• In the real world, it takes time and money to do the deal, and there are risks

• Four types of transaction costs– Uncertainty—all outcomes are not known in advance

– Asymmetric information—some parties know more than others

– Opportunism—some actors transact with guile (deception, self-serving behaviors)

– Asset specificity—The difference in value between the designed use and the next best use

The make or buy decision

• A key decision for strategists is whether the firm should make critical inputs or buy them on the market

• Making it yourself is costly:– Loss of market incentives to hold costs down– Bureaucratic costs of supervision and governance

• Buying it on the market may be costly– Risk of opportunism impedes specialized asset investments– Costs of dealing with uncertain outcomes potentially high

• The critical question: When to make (integrate, acquire, alliance) and when to buy (contract)

The make or buy decision

K = level of asset specificity

C= differential cost of in-house production

G= differential cost of governance in-house

Cost

C

G

kk’k*

C + G

Managing in a Williamsonian world

• At low levels of specificity (below k*), the firm is better off to buy the input on the market

• At moderate levels of specificity (between k* and k’), the firm benefits from a joint-venture, alliance, or hybrid form of make-buy

• At high levels of specificity (above k’), the firm should integrate (acquire) the input and produce it in-house

Markets with externalities

The problem of externalities

• Externalities occur when the impacts of any transaction are not limited to the private parties involved

– Negative—pollution in the Grand Canyon, Airplane landings

– Positive—cool music, the value of MS Office

• Externalities represent costs (benefits) not factored into private (price) decision making

• Private decision rules will over-supply goods with negative externalities

• Private decision rules will under-supply goods with positive externalities

$

Quantity

MCP

P

SMCN

SMCP

QP QSPQN

Managing in a world with externalities

• A popular solution: internalize the externality through taxes– Pollution tax credits

• Externalities cannot be factored away, or claimed as “outside” of our concern

• Externalities force managers to consider the social costs/benefits of their actions