PART IV MARKET STRUCTURE
IV.1 ENTRY DETERRENCE
- Determinants of market structure?
! Technology
! Market size
! Strategic behavior
! Information
- Often associated with entry barriers
- We ignore here legal and political factors that are associated with entry barriers
IV.1.1 TECHNOLOGY
Economies of scale (Definition)
- Constant returns to scale: when the average cost of production is constant.
- Increasing returns to scale (or economies of scale): when the average cost decline with output.
- Equivalently, with economies of scale, the total cost of duplicating the production is lower than the duplicated cost.
- Example: C(q) = F + cq (economies of scale)
! C(q)/q = F/q + c, decreasing in q
! C(kq) = F + ckq < kC(q) = kF + ckq
Economies of scope (Definition)
- Economies of scope: when the cost of producing quantities q1 and q2 of two distinct products together is lower than producing them separately
- Example: Bus between Newark, DE and Washington DC and Bus between Washington DC and Newark, DE
Economies of scale and market structure
The model
- Cost function: C(q) = F + cq (economies of scale) - Demand function: P = a – bQ
- Total quantity: Q = Σqi
- b reflects the market size. A lower b reflects a larger market and vice versa - Free entry
- Competition à la Cournot
The equilibrium
- Firm i sets qi so as to maximize profits Πi = (a – bQ – c)qi – F
- FOC a – bQ – c – bqi = 0
- Symmetry implies a – bnqi – c – bqi = 0
€
⇔ qi = a −c b(n+1)
- Equilibrium profits:
€
Πi(n)= a−bn a−c
b(n+1) −c
⎛
⎝ ⎜ ⎞
⎠ ⎟ a−c
b(n+1) −F = 1 b
a−c n+1
⎛
⎝ ⎜ ⎞
⎠ ⎟
2
−F
- Equilibrium profits are decreasing in n
Long-run free-entry equilibrium (endogenous market structure)
- No active firm wishes to leave the market AND no inactive firm wishes to enter
- Specifically, the equilibrium number of firms,
€
n ˆ , has to be such that
!
€
Π( ˆ n )≥ 0 and
€
Π( ˆ n +1)≤0
- In our model
!
€
Πi( ˆ n )= 1 b
a−c n ˆ +1
⎛
⎝ ⎜ ⎞
⎠ ⎟
2
−F ≥0 ≥ Πi( ˆ n +1)= 1 b
a−c n ˆ +2
⎛
⎝ ⎜ ⎞
⎠ ⎟
2
−F
- Therefore,
€
n ˆ , is the only integer such that
!
€
a −c
bF −2 ≤ n ˆ ≤ a−c bF −1
- The number of firms at free-entry equilibrium is
! Increasing in a and in the size of the market (inverse of b)
! The relationship between
€
n ˆ and market size is not proportional because of the price effect: When
€
n ˆ increases, the market is more competitive, the price decreases, so do the price margin and the firms’ profits, which
limits the number of firms that can be active on the market.
!
€
n ˆ is decreasing in the cost parameters F and c
! Higher economies of scale (higher F) result in a more concentrated market at equilibrium
- Comments
! The free-entry equilibrium is compatible with large profits for active firms
! Asymmetric information about the market conditions. Therefore, the entry decision is even more risky when fixed costs are high
! The active firms can behave opportunistically to prevent new entries
IV.1.2 STRATEGIC BEHAVIOR
Limit pricing
- Active firms set or threaten with setting a price so low that entry costs would not be covered.
- Condition: active firms strategically maintain excess capacity of production - How to judge excess capacity from a policy perspective? Peak demand…
- Credible threat? Time inconsistency? Commitment?
- Asymmetric information about the costs of the active firm. The active firm manipulate its price so as to pretend its costs are lower than they actually are.
Product proliferation
- If the price is given and the firms choose location (product positioning) only - Let 2 firms choose their location sequentially at a fixed cost F
- If the choices are about a single location, both choose the median at equilibrium - If the first firm can choose several locations (each at a fixed cost F), it can be
optimal to choose more than one location to prevent the entry of the other firm.
- This holds true if F is not too low (so that another firm is better off remaining
inactive) and not too high (so that it is better to be a monopoly with more than one location)
- Example: Breakfast cereals in the US
