Assignment 5
beegirlie61
SanterreNeun_Chapter8.pptxChapter 8
Structure, Conduct, Performance,
and Market Analysis
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Structure, Conduct, and Performance Paradigm
Industrial organization (IO)
Behavior of firms and markets
The IO triad: SCP paradigm
Market structure
The field of operation of each firm
Market conduct
Pricing, promotion, and research and development activities
Market performance
the degree of production and allocative efficiencies, equity, and technological progress
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Figure 8.1 - The Industrial Organization Triad
Basic Conditions
Supply
Technology
Unionization
Legal environment
Economies of scale
Demand
Price elasticity
Demand conditions
Market Structure
Number, type, and size distribution of sellers and payers
Type of product; Information asymmetry
Barriers to entry (licenses, patents, cost structure)
Objectives
Profit maximization
Quantity maximization
Quality maximization
Discretionary spending
Other
Public Policies
Taxes and subsidies
Antitrust regulations
Price regulations
Certificate of need laws
Peer review organizations
Conduct
Pricing behavior
Product promotion
Research and development
Performance
Production and allocation efficiency
Equity; Technological progress
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Structure, Conduct, and Performance Paradigm
The IO triad predicts
The structure of an industry
In conjunction with the objectives of firms
Determines the conduct of the firms
Which in turn influences market performance
Significant feedback effects exist among the three elements
The structure of the market indirectly affects industrial performance through its impact on the market conduct of individual firms
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Structure, Conduct, and Performance Paradigm
If markets do not produce desired levels of performance
Public policies should be aimed at correcting this failure of the market
Market power
Firm’s ability to restrict output (or quality) and thereby raise price.
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Table 8.1 - Market Structure and Market Power
| Degree of Market Power | ||||
| 0% . . . 100% | ||||
| Characteristics | Perfect Competition | Monopolistic Competition | Oligopoly | Pure Monopoly |
| Number of sellers | Many | Many | Few, dominant | One |
| Individual firm’s market share | Tiny | Small | Large | 100% |
| Type of product | Homogeneous | Differentiated | Homogeneous or differentiated | Homogeneous by definition |
| Barriers to entry | None | None | Substantial | Complete |
| Buyer information | Perfect | Slightly imperfect | Perfect or imperfect | Perfect or imperfect |
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Is a Perfectly Competitive Market Relevant to Medical Care?
Features of health care industries not abiding assumptions of a perfectly competitive market structure
Not-for-profit medical enterprises
Physician licensure
Insurance coverage
Consumers lack perfect information
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A Model of Supply and Demand
Perfectly competitive market
Buyers and sellers are price takers
Buyer maximizes utility
Marginal private benefit equals market price
Firm maximizes profit
Market price equals marginal private cost
Market clearing price
Acts as a coordination device
Reduces shortages and surpluses
At the point of intersection of demand and supply
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Figure 8.2 - The Perfectly Competitive Outcome
9
Quantity (Q)
Q0
Price per unit (P)
D = MPB
A
S = MPC
G
C
P0
Market demand, D, represents the marginal private benefit, MPB, associated with the consumption of various units of a good. MPB is downward sloping to reflect the law of diminishing marginal utility.
Market supply, S, reflects the marginal private cost, MPC, of production and is upward sloping to reflect the law of diminishing marginal productivity.
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A Model of Supply and Demand
Perfectly competitive market
Consumer surplus (Area P0AC in Figure 8–2)
Difference between what the consumer would be willing to pay and what the consumer actually has to pay
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A Model of Supply and Demand
Producer surplus (Area P0CG in in Figure 8–2)
Difference between the actual price received by the seller and the required price as reflected in the marginal costs of production
Total net gains from trade = consumer surplus + producer surplus
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A Model of Supply and Demand
Allocative efficiency
If demand represents full marginal social benefit
MPB = MSB
And supply represents full marginal social cost
MPC = MSC
Inefficient allocation of resources
If others, in addition to market participants, are affected either beneficially or adversely by a market exchange
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Comparative Static Analysis
Changes in market conditions
Influence the positions of the demand and supply curves
Cause the equilibrium levels of price and output to adjust
Comparative static analysis
Examines the changes in market conditions and the consequent effects
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Comparative Static Analysis
Factors that change the demand
Number of buyers, consumer tastes, income, and the prices of substitutes and complements
Factors that change the supply
Input prices and technology
Greater buyer income
Higher price and quantity
Cost-saving technology
Decline in price; increase in quantity
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Figure 8.4 - Effects of an Increase in Supply
Quantity of generic aspirin (Q)
Q0
Price per unit (P)
D
S0
P0
P1
Q1
S1
B
A
Eventually price decreases in the market from P0 to P1 in response to the increase in demand. Quantity increases from Q0 to Q1.
Supply increases from S0 to S1. As a result, a temporary surplus of horizontal distance AB is created in the market at the existing price of P0.
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Long-Run Entry and Exit in a Perfectly Competitive Market
Long-run entry of a new firm
Shifts short-run market supply curve to the right
Lowers price and eliminates excess profits
Long-run exit of an existing firm
Shifts short-run market supply to the left
Raises price and eliminates economic losses
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Long-Run Entry and Exit in a Perfectly Competitive Market
Typical perfectly competitive firm
Earns just enough revenues to cover opportunity cost of every input (normal profits) in the long run
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Using Supply and Demand to Explain Rising Health Care Costs
Rising income, an aging population, and a falling out-of-pocket price
Demand shifts to the right
Higher price and quantity of medical care demanded
Wage increase in medical care industry unmatched with increases in productivity
Supply shifts to the left
Price of medical care increased
Higher health care expenditures
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Using Supply and Demand to Explain Rising Health Care Costs
Cost-enhancing technologies
Higher quality of medical care
Supply curve shifts to the left
Demand curve shifts to the right
Higher medical care expenditures
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The Monopoly Model of Market Behavior and Performance
Monopoly
Least competitive market structure
One firm is the sole provider of a product
Perfect barriers to entry
Potential for market power: socially undesirable
Price can be influenced by reducing quantity
Downward sloping market demand curve
Marginal revenue (MR) is less than price (P)
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Monopoly versus Perfect Competition
Monopolist
Charges a higher price and produces less
Smaller consumer surplus
Bigger producer surplus
Smaller total surplus
Deadweight loss
Perfectly competitive firm
Charges a lower price and produces more
Larger consumer surplus
Smaller producer surplus
Greater total surplus
No deadweight loss
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Figure 8.5 - The Monopoly Outcome
Quantity of generic aspirin (Q)
QC
Price per unit (P)
D = MPB
A
S = MPC
G
C
PC
MR
F
QM
K
PM
M
A monopoly produces at QM where MR = MC and charges price PM. Reflecting that society’s scarce resources are misallocated, a deadweight loss of area MCF is created by the monopolist.
The perfectly competitive outcome is represented by point C. Consumer surplus is larger (the area APCC compared to the area APMM in case of monopoly).
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Barriers to Entry
Barriers to entry
Make it costly for new firms to enter market
Probable reasons
Exclusive control over a necessary input
Presence of sunk costs
Absolute cost advantage
Limit pricing
Legal restrictions
Licenses
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Figure 8.6 - Scale Economies as an Entry Barrier
Quantity of medical care (q)
qE
Costs of
medical
care
CE
ATC
qX
CX
An entrant with a relatively small volume of output of qE produces at a cost of CE. Because of the scale economies, an existing firm can charge a price slightly below CE and discourage the entry from actually entering the market.
The declining average total cost curve, ATC reflects scale economies in production. An existing firm producing a large volume of output at qX produces at a cost of CX.
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The Buyer Side of the Market
Real world scenario
Buyers can possess varying degrees of market power
Exact outcome depends upon the relative bargaining power of the buyers and sellers
Monopsony: market with a single buyer
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Monopolistic Competition and Product Differentiation
Monopolistic competition
Many sellers with relatively small market shares
Somewhat differentiated product
Advertising, quality differences, location preferences
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Monopolistic Competition and Product Differentiation
No barriers to entry
Slightly asymmetric information among buyers
Highly elastic market demand curve
More differentiated product: less elastic demand
Some market power over output
Brand loyalty
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Monopolistic Competition and Product Differentiation
Short run
A firm may earn economic profit
P > ATC, at the level of output where MC = MR
Other firms are attracted to the industry
Long run
Market share for each firm diminishes
Demand faced by each firm falls
Economic profits becomes zero
More elastic demand than in the short run
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Figure 8.7 - Long-Run Equilibrium for a Monopolistically Competitive Firm
Quantity (q)
q0
Price per unit (P)
d
P0
MR
ATC
MC
In the long run, the representative monopolistically competitive firm produces at q0 where MR = MC and charges a price equal to average total costs.
Because there are no meaningful entry barriers, firms continue to enter the market until the representative firm earns only a normal profit.
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Pro-competitive and Anticompetitive Aspects of Product Differentiation
Pro-competitive
Advertising
Promotes lower prices and higher quality
Brand names and trademarks
Anticompetitive
Advertising
Promotional activities to establish brand loyalty
Product differentiation
Influences consumer demand and preferences
Creates barriers to entry
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Oligopoly
Market structure
Few dominant firms
Substantial barriers to entry
Market power: individually or collectively
Mutual interdependence
Dominant firms must be sufficiently sized and limited
The behavior of any one firm influences the pricing and output decisions of the other major firms in the market
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Collusive Oligopoly
All the firms in the industry cooperate
Joint profits maximization
Deadweight loss: misallocation of resources
Overt collusion
Representatives of the firms formally meet
To coordinate prices and divide up markets
Tacit collusion
Firms informally coordinate their prices
Price leadership model
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Collusive Oligopoly
Difficulties associated with collusion
Sherman Antitrust Act
Informal tacit collusion
Hard to interpret the motive (s) behind the price adjustments made by the industry leader
Cost differences
Low entry barriers
More firms in the industry
Incentives to cheat on the agreement
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Competitive Oligopoly
Firms in a competitive oligopoly
Rivals may not coordinate their behavior
Aggressively seek to individually maximize their own profits
Each firm has an incentive to lower its price to marginal cost
Market output
Price equals marginal cost
Resources are efficiently allocated
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Collusive or Competitive Oligopoly?
Conjectural variations
Reaction of rivals to a firm’s output decision
Determine market output and price
Depend on firm characteristics and the market conditions
Matching behavior
Fewer firms; high barriers to entry
Social and historical ties
Closer proximity
Bounded rationality
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Oligopolistic Behavior in Medical Care Markets
Blood banking industry
Two dominant not-for-profit firms ($2 billion industry)
American Red Cross: 46% market share
America’s Blood Centers (ABC): 47% market share
In 1998, American Red Cross increased its national market share to 65%
Competitive oligopoly model
Lower price prevailed in the regions where both firms coexisted than in the regions where only one firm operated
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Oligopolistic Behavior in Medical Care Markets
Stent market
Johnson and Johnson (J&J)
In 1997, stent market: $600 million; J&J held 95%
In 1998, stent market: $1 billion; J&J held 8%
J&J angered key customers
Rigid pricing and denying discounts
Pressure on Food and Drug Administration (FDA) to approve new stents as quickly as possible
Guidant Corporation
Approval of patent (took 45 days)
Market share: 70%
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Defining Relevant Market, Measuring Concentration & Identifying Market Power
Better understand & predict market behavior and performance
Determine precise boundaries of a market
Determine precise product being bought & sold
Identify the number of sellers in a market area
Theoretical issues and practical limitations when defining markets
How market concentration and market power are measured in practice
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The Relevant Product and Geographical Markets
Two dimensions of market
Relevant product market (RPM)
Substitutability of goods and services
Relevant geographical market (RGM)
Establishes the spatial boundaries in which a set of buyers purchase their products
Different levels can be local, regional, national, or international
Includes all of the seller locations to which buyers might switch
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Measuring Market Concentration
Concentration ratio
Percentage of industry output produced by the largest firms in an industry
CR4 = sum of market shares of four largest firms
Ranges between 0 and 100%
CR4 ≥ 60%: tightly oligopolistic
CR4 between 40% and 60%: loose oligopoly
CR4 ≤ 40%: reasonably competitive
Shortcoming: fails to reveal the distribution of industry output among the largest firms
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Measuring Market Concentration
Herfindahl-Hirschman index (HHI)
Sum the squared market shares of all the firms in the relevant market
HHI = Σ Si2 = S12 + … + SN2
Si: percentage market share of the ith firm
0< HHI ≤ 10,000
HHI = 10,000
Market is dominated by one firm
HHI is closer to zero
Industry is less concentrated or more structurally competitive
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Identifying Market Power
Lerner index of monopoly power (L)
Monopoly - market power
Measured by how high price (P) can be elevated above the marginal costs (MC) of production
L = (P –MC) / P = 1 / |EM|
EM: price elasticity of demand
L = 0: perfectly competitive firm
EM = ∞: perfectly elastic demand curve
L = π / TR
Higher ratio of economic profits (π) to total revenues (TR) or sales means higher market power
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Identifying Market Power
Drawing inferences about market power from profit data
Reported rates represent accounting and not economic profits
Even perfectly competitive firms earn a normal, economic profit rate
Investments in some industries are riskier than others
A perfectly competitive industry earns a normal rate of return in the long run
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