R.E.

Marks

ECL 3-1

R.E. Marks

ECL 3-2

3.1 Market Structure

3. Market Structure and Competition

The structure of a market refers to the number and
characteristics of the firms in it.
Many industries or markets are dominated by a
few firms. Other contain many sellers.
In some markets, products are homogeneous:
sellers can meet the needs of consumers equally
well:
metals, chemicals, extractive industries, farming
In other markets, products are heterogeneous:
different customers may have preferences for
different sellers:
include branded products
Interplay between market structure and
competition:
Highly concentrated oligopoly; two firms over

3.1.1 Market definition Identifying the market or

markets in which a firm operates is known as
market definition:
that set of suppliers and demanders whose
trading establishes the price of a good or
service
Thus two sellers are in the same market if one
sellers production and pricing decisions materially
affect the price the other seller can charge.

3.1.1.1 Qualitative approaches: Based on the idea

that two products are in the same market if they
are close substitutes.
Two products X and Y are substitutes if, when the
price of X rises and the price of Y is unchanged,
purchases of X fall and purchases of Y rise.
Products tend to be close substitutes when:
1.

Same or similar product performance

characteristics.
That is, What does a product do for
consumers?
How do the attributes of two products
overlap?

2.

Same or similar occasions for use.

When, where, and how a product is used.

90% of sales.
Faced with excess capacity, both firms willing

to slash prices to protect market share,

although generally have been unwilling to cut
prices to get new business.
Price wars low prices and low profits.

R.E. Marks

3.

ECL 3-3

Sold in the same geographical market.

Different geographical areas if:
a.

sold in different locations

b.

costly to transport the goods,

c. costly for consumers to travel and buy

the products
The qualitative approach, although commonly
used, has several shortcomings:
1.

identifying substitutes based on product

performance characteristics is subjective and
imprecise.
much debate about market definitions.

2.

Difficult to calibrate the extent of

substitution.

3.

Difficult to assess the importance of

transport costs in an individuals choices.

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ECL 3-4

Case: Substitutes and Competition in the Post

Office
Almost always the P.O. is a government-owned or
-regulated monopoly.
New technology is reducing the importance of a
universal postal service: mobile phones, TV, faxes,
email, the Internet, etc.
Access to other forms of communication continues
to grow.
Reasons given for government monopoly:
1.

Universal, equal access.

2.

Unnecessarily costly to have two

organisations delivering mail to the same
address (consider rural deliveries).

3.

Control the monopoly to keep prices below

monopoly levels.

Traditionally, post offices sometimes very

inefficient (high AC), but in Australia since 1975
(when PMGs Dept split into Telecom and
Australia Post, both later corporatised) such
inefficiencies have been reduced.
In some countries the statutory monopoly doesnt
extend to parcels or express mail delivery.
TNT, the Dutch P.O., the N.Z. P.O.
Competition from close substitutes: fax, phone (for
bill payments), email.
Varied P.O. responses

R.E. Marks

ECL 3-5

3.1.1.2 Quantitative approaches to defining markets

& identifying competitors
Four approaches:
1.

Demand elasticities.

2.

Residual demand curves.

3.

Price correlations.

4.

Trade flows.

3.1.1.2.1 Demand elasticities

If a firm raises its price, and as a result,
loses most of its custom to other firms, then it

has many competitors.

keeps most or all of its custom, then it faces

little competition.
The size of consumer reaction to changes in price
is measured by the own-price elasticity of demand
(see Lecture 1-17):
Qx L Qx
________
x =
,
Px L Px
where x is the own-price elasticity facing firm X,
Qx is the quantity (not sales revenue) sold by firm
X, and Px is the price.
Since Q and P the changes in quantity and
price will be of opposite sign, the negative sign
gives a positive measure of elasticity.

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ECL 3-6

A high x does not necessarily imply many close

substitutes: recall from Lecture 1-23 that a firm
will always push up price until demand is elastic.
At that level, a further price rise would reduce
sales volume (quantity, not revenue) without
consumers switching to any close substitute.
But knowledge of substitutes firms can assess
changes in x and adjust their prices, as market
conditions change.
e.g. Geelong cement producers
From experience, a firm may find that a 10% price
rise, cet. par., results a 20% fall in sales, so x = 2.
From the mark-up formula (Lecture 1-23),
if MC = $10/unit, then
MC
10
__________
= _______
= $20
P=
(1 12)
(1 1/ x )
will maximise the firms profits.
If a new entrant appears and the firm believes its
customers view its product as a substitute (maybe
its sales fall slightly), then its x will probably
have increased, and so it should lower its price, as
the mark-up formula suggests.

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ECL 3-7

A group of sellers can benefit from knowing , the

group rather than the individual sellers :
if one seller with many substitutes raises its

price, it will lose much business to substitutes.

if the group raise their prices in concert, then

the group may be low (if there are no close

substitutes) and they will increase their TR
and their profits.

Such pricing coordination (collusion) will harm

consumers and impose a Dead-Weight Loss

(Lecture 1-31) on society.
It is illegal.

Identify substitutes by using the cross-price

elasticity of demand:
the % change in quantity of product Y in
response to a 1% change in the price Px of
product X:
Qy L Qy
________
yx =
Px L Px
When yx is positive, X and Y are substitutes.
When yx is negative, X and Y are complements.
Possible to measure cross-price elasticities:
estimated that a 10% rise in the price of natural
gas would lead to a 1.5% fall in the demand for
electricity, a substitute, cet. par.: yx = 0.15.

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ECL 3-8

3.1.1.2.2 Residual demand analysis

Consider the Geelong cement producers: if they
could raise their prices collectively by only 1%
before it became profitable for Melbourne cement
producers to enter the market and compete
business away from Geelong producers, then the
Geelong area is not a well-defined geographical
market.
If, by contrast, Geelong producers could profitably
raise their prices by 15%, then Geelong does
constitute a well-defined market.
If a market is well-defined, then the pricing
decision of sellers within the market will not be
constrained by the possibility that buyers will
switch to sellers outside the market.
If pricing within is constrained, then the market
definition is too narrow, and should include the
outsiders: the basis of residual demand analysis.
A difficulty: to assess by how much a group of
firms acting together could raise the price
profitably may be no record, unless they have
been colluding; past price rises together may have
been in response to a common increase in taxes or
in wage rates or in other costs.
If the group have raised their prices alone in the
past because of such localised cost or tax effects
and their TR rose, then can conclude that the
group faces few substitutes and so constitutes a
well-defined market

R.E. Marks

ECL 3-9

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ECL 3-10

3.1.1.2.3 Price correlations

3.1.1.2.4 Trade flows

If two sellers are in the same market, then they

should be subject to the same demand forces.

If the cost of transporting the product (or the

buyer) from one area to another is prohibitively
high, then identical products sold in different
geographical markets will not be good substitutes,
and not in the same market.

So a higher demand for one should also increase

for the other, and both should increase their
prices.
If two sellers are close substitutes, then their Ps
should be highly correlated.
But the opposite may not hold:
may be difficult to determine whether products
with high price correlations are competitors in
markets for inputs (so they respond to common
cost changes) or outputs or both.
Limited use in antitrust cases.

To identify a geographical market, can use

government classifications, but can lead to errors,
without knowledge of actual product or buyer
flows.
Or: directly examine flows of goods and services
across geographical regions to identify possible
competitors:
Not enough to survey one shops customers to

find out where they shop, because this ignores

those who live nearby but shop elsewhere.
Instead, a two-stage process:

1.

Ask its customers where they live:

identify its catchment area, in which other
similar shops will be substitutes.

2.

Survey all residents of the catchment area

to ascertain who shop outside the area: if
many do, then there is competition from
outside the catchment area.

R.E. Marks

ECL 3-11

Method frequently used in antitrust cases. A

geographical market for a product, and the
competitors within, are properly identified if:
1.
2.

firms in that market draw most of their

customers from that area,
customers living in the area must make most
of their purchases from sellers in that
market.

3.1.1.2.5 Other approaches

Define markets according to the Australian & New
Zealand Standard Industrial Classification
(ANZSIC), although this is used for classifying
establishments (or organisations) that carry out
similar economic activities, not products or
markets.
The scheme uses a four-digit identifier, with each
digit representing a finer degree of classification
(17 Divisions, to Subdivisions, to Groups, to 465
Classes, the finest).
A Class must be economically significant: in
Australia a minimum annual turnover of $200m
or employment of 3,500.
But beware: paperboard tubes are listed under
class 2615 (Other Paper Products) although their
plastic substitutes fall under class 3434
(Manufacture of Plastics Not Elsewhere
Classified). (These numbers are from the nowobsolete ASIC, as is the table on p. 3-14 below.)

R.E. Marks

ECL 3-12

Case: Coca-Colas market

In 1986 Coca-Cola sought to acquire the Dr Pepper
Company: the largest buying the fourth largest
seller of carbonated soft drinks.
The FTC sought an injunction to block the merger
on the grounds that it would violate the
prohibition against any acquisition of stock or
assets of a company that might substantially
lessen competition.
C-C apparently sought the deal to acquire, and
more fully exploit, the Dr P trademark. C-Cs
marketing skills and research ability cited as two
factors that would allow this.
Perhaps because Pepsi-Cola had been trying, but
abandoned, to buy Seven-Up.
The injunction was supported, and the merger
abandoned.
Proper market analysis directs attention to the
nature of the products that the acquirer and the
acquired company principally sell, the channels of
distribution ..., the outlets they employ to
distribute their products to the ultimate consumer,
and the geographic areas they mutually serve.
Not only the end-user market but also the
intermediate markets.

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ECL 3-13

The FTC: the market was carbonated soft drinks:

the merger would increase C-Cs market share by
4.6% nationwide, and by 10 to 20% in many
geographic submarkets (distribution channels).
Given C-Cs share of 40 to 50% already, the
merger would significantly reduce competition.
C-C: the market: all ... beverages including tap
water , and hence the merger would have a
negligible effect on competition.
The judge determined that carbonated soft drinks
was the product market for antitrust purposes:
relying on the products
distinctive characteristics and uses,
distinct consumers,
distinct prices, and
sensitivity to price changes.

Carbonated soft drink makers constrain each

others pricing decisions, but are unconstrained by
other drinks a well-defined market.

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ECL 3-14

3.1.2 Measuring market structure

A quick characterisation of a market is
concentrated (having just a few sellers) or
unconcentrated.
Market structure: the number and distribution of
firms in a market (Lecture 2-26). Most theories:
market performance depends on characteristics of
its largest firms, not the smallest or fringe firms.
A common measure is the N-firm concentration
ratio: the combined market share of the N largest
firms in the market.

______________________________________________________________
obsolete
Percentage of turnover Total
ASIC
accounted for by:
number
code
Industry
Largest Largest Largest of firms
four
eight twenty
______________________________________________________________
2190
2163
2945
2770
3231
2751
2454
2642
346
2872
2122
2765
3353

Tobacco products
100
100
100
3
Biscuits
95
99
100
23
Steel pipes & tubes
92
95
99
37
Petroleum refining
85
100
100
8
Motor vehicles
84
95
100
32
Chemical fertilisers
81
98
100
19
Foundation garments
73
97
100
12
Printing & publishing
71
81
92
183
Rubber products
69
77
86
158
Ready mixed concrete
69
75
83
178
Butter
58
84
100
19
Soap & other detergents
48
60
81
114
Refrigerators &
household appliances
46
61
80
167
3482 Jewellery & silverware
15
25
43
198
2644
Printing
&
bookbinding
14
21
33
1506
______________________________________________________________

Selected Australian Industries 198283

Caves et al., Australian Industry, 1987.

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ECL 3-15

The table shows not-so-recent four-firm, eightfirm, and twenty-firm concentration ratios for
selected Australian industries. in 198283, using
the now-obsolete ASIC (see p. 3-11 above).
Another measure is the Herfindahl index (H.I.):
the sum of the squared market shares of all firms
in the market:
S = (Si )2
i

e.g. a market with two equal firms in it has an H.I.

of .52 + .52 = .5
The H.I. of a market with N equal-sized firms is
1 L N.
The reciprocal of the H.I. is known as the
numbers-equivalent of firms.
Ignore small firms since .01 .01 is negligible.
The H.I. changes with changes in the relative size
of the largest firms, whereas the N-firm
concentration ratio does not.

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ECL 3-16

3.2 Linking Market Structure & Competition

Many models link market structure to the conduct
(behaviour) and (financial) performance of its
firms.
Lecture 1-23 to 1-28 discussed models of price
determination:
as a firm faces more elastic demand, the
mark-up (or margin) between P and MC
narrows.
Extreme: firms face horizontal demand curves of
infinite elasticity, so that P = MC, and there is
no DWL: an efficient allocation (Lecture 1-31).
With free entry and exit, all (economic) profits
competed away, so that
P = MC = min AC at QMES
Other extreme: single seller or monopolist, and P >
MC and inefficient for two reasons:
1.

a Dead-Weight Loss (DWL)

2.

operating with AC > min AC and Q <

QMES .

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ECL 3-17

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ECL 3-18

Suggests firms face a continuum of pricing

possibilities, depending on the nature of the
competition they face:
_ ______________________________________________
Nature of
Range of
Intensity of
Competition
H.I.s
Price
Competition
_ ______________________________________________
Perfect
Usually < 0.2 Fierce
competition
Monopolistic Usually < 0.2 May be fierce or light,
competition
depending on product
differentiation
Oligopoly
0.2 to 0.7
ditto
Monopoly
0.7 and above Usually light, unless
threatened by entry.
_ ______________________________________________

3.2.1 Perfect competition

The H.I.s are suggestive only:

its only decision is how much to produce and

sell;

Later we see fierce price competition with only

two firms.
In Lecture 6 we examine condition for a

contestable market, where a single firm prices

competitively.
Need to assess the particular circumstances of the
competitive interaction of firms, and not rely solely
on the H.I. or concentration ratios.

(See Lecture 1-26 to 1-28.)

Many sellers of a homogeneous good and many
well-informed buyers who costlessly shop around
for the lowest price.
a single market price, determined by the
interaction of all sellers and buyers, beyond the
control of any.
each firm faces an infinitely elastic (and
horizontal) demand:
sells nothing if its price is at all greater than
the market, and
throws money away if it sells below the market;

chooses Q to set MC (Q) = P, (see Lecture 1-26).

From the mark-up formula (Lecture 1-23), the
percentage margin contribution (PCM) =
(P MC)/P, so that the profit-maximisation
condition can be written:
1
__
PCM =

With perfect competition, = , so the PCM = 0.

R.E. Marks

ECL 3-19

Market conditions will tend to drive down prices

when two or more of:

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ECL 3-20

3.2.1.1 Many sellers

1.

Many sellers

The industry is led by its dumbest competitors

vainly seeking market share by price cutting.

2.

Consumers perceive the product to be

homogeneous

But collusive high prices hurt buyers, so exist

competition laws (antitrust, trade practices).

3.

Excess capacity exists

In practice, unusual for more than a handful of

sellers to raise prices above MC for a sustained
period:

Markets for many metals and agricultural

commodities, with fierce price competition and low
(economic) profits as P MC.
Most other markets are not literally perfectly
competitive, but can exhibit fierce price
competition at times.

1.

The greater the number of sellers, the

greater the difficulty of agreeing who cuts
production to support higher prices

2.

The greater the number of sellers, the

greater the chance of one or more cheating
on an agreement, once reached, and
expanding production and sales.
May trigger a price war.
Small firms may cheat to capture
economies of scale (Lecture 2-16) and
learning economies (Lecture 2-21).
Difficult for larger firms to agree on
suitable punishment (why not lowering
prices?)

3.

In an industry with many sellers, likely to be

a diversity of seller pricing preferences: a
seller with low costs may prefer a low selling
price, if the short-term benefits exceed the
long-term costs of price instability.
e.g. U.S. airlines flying under bankruptcy
protection price wars as coups de grace?

R.E. Marks

ECL 3-21

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ECL 3-22

Case: The OPEC cartel

3.2.1.2 Homogeneous product

See Daniel Yergins The Prize (NY: Simon &

Schuster, 1991)

Increased sales from three different sources after a

price fall:

In 1960 OPEC was formed as a cartel to counter

efforts by the oil majors to lower the prices they
paid for oil imported into the industrialised
countries.
In the 1980s OPEC explicitly tried to raise the
price of oil by setting quotas to restrict their
output; Saudi Arabia was the swing producer
and cut its output to maintain prices, as agreed
Difficult to sustain: during the Iran-Iraq War,
countries cheated, and prices fell. Further
pressure from the competitive fringe producers,
such as the North Sea producers price falls.
In November 1985 the Saudis cried Uncle and
fed up with their production cutbacks to support
the world price with others cheating on 1
January 1986 the world price of oil dropped in free
fall from US$35/bbl to about $12/bbl.
Today, OPEC produces less than 50%, and
apparently has negligible effect on world prices.
Other efforts to cartelise international
commodities: copper, tin, coffee, tea, cocoa. Some
with short-term success: bauxite, uranium.
Diamonds, via De Beers Central Selling
Organisation, have had longer-term success, even
with the Russians; will Argyle successfully break
away?

1.

Increased sales to existing customers.

2.

First-time sales to new customers, not

previously buying at all.

3.

Sales to customers who had switched from

buying elsewhere to take advantage of the
lower price.

Homogeneous product: no variance from one seller

to another, and customers will switch to get a
lower price, which intensifies price competition.
Shares of BHP, ounces of 24-karat gold are
homogeneous.
Wheat, wool, coal apparently homogeneous
but graded.
In cases where nearly all buyers can agree that a
given good offers proportionately higher or lower
value than another product, the threat of
consumer switching forces prices to keep that fixed
proportion.

R.E. Marks

ECL 3-23

R.E. Marks

ECL 3-24

3.2.1.3 Excess capacity

Case: Pricing in the Airline Industry

With production processes with high FCs (see

Lecture 2-26) MC can be well below AC over a
wide range of output; only when production equals
capacity at QMES does MC equal and then exceed
AC.
_________________________________________
Annual
TVC
TFC
TC
AC
Output
$m/yr
$m/yr
$m/yr
$/unit
_________________________________________
10,000
1
12
13
1300
20,000
2
12
14
700
30,000
3
12
15
500
40,000
4
12
16
400
50,000
8
12
20
400
_________________________________________

The U.S. airline industry: frequent price wars and

large financial losses. losses tied to industry
cost structure and the nature of competition?

Plant has a capacity QMES of 50,000/yr, but has

firm orders only for 10,000. Confident that at a
price of $300/unit it can sell another 10,000 by
stealing a major customer from one of its
competitors.

Flights with different airlines almost

homogeneous (what role do FF programs play
here?).

Should it do so?

Given that MC << AC, the airlines can lose much

money: cover MC, but not FC.

Yes, because TR = $3m > TC = $1m, so long as

it can sell at $300 (or above an AVC of $100/unit).
In the long run, P must be above AC, or firms may
exit the industry, unless the firm capacity is
industry-specific, with very low or zero opportunity
costs: remain.

Three kinds of costs:

1.

Flight-sensitive costs; fixed once the schedule

is set.

2.

Traffic-sensitive costs; vary with the number

of passengers. Only a small % of TC.

3.

Fixed overhead costs; fixed before the

schedule is set.

Airline is better off selling an empty seat at near

MC, but below AC, than flying with empty seats.

Great pressures, esp. when demand is low, to fill

planes with low, almost-MC fares.

Q: Local duopoly (two sellers) which is similar?.

R.E. Marks

ECL 3-25

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ECL 3-26

3.2.2 Monopolistic competition

3.2.2.1 Graphical depiction

A market with two main features:

If all firms set exactly the same price in a market

of many (N) differentiated sellers, who are well
informed. A typical seller will have 1/N of the
market.

1.

Many sellers, so no one seller can influence

its rivals directly.

2.

Differentiated products: slightly different,

perhaps branded.

Sometimes there is consensus about which

products are better (vertical differentiation),
sometimes products just differ (horizontal
differentiation), for instance, by geographical
location or by colour.
Possible to think of any single measure in which
products differ as location.
If the gain from switching products is greater than
the cost of doing so (reflecting the distance
between products), then buyers will switch.
Unless:
preferences are highly idiosyncratic, or
buyers lack information about alternatives, or
buyers see a relatively higher price as a proxy

for quality.

The demand curve facing each seller will be

relative inelastic, and reflects not switching (since
all sellers change prices together) but the Law of
Demand (Lecture 1-16).
If, however, one seller lowers its price while the
others dont, then it sells more, because:
its existing customers demand more, and
it steals customers who switch from other

sellers.
In this case it faces a much more elastic demand
curve, and the seller has much to gain by lowering
its price, and the PCMs from profit-maximising
behaviour will be fairly small (see p.3-18).
If there is little switching, the price elasticity of
demand will be smaller, and the PCMs higher.

R.E. Marks

ECL 3-27

R.E. Marks

ECL 3-28

3.2.2.2 Entry

3.2.3 Oligopoly

In differentiated product markets:

With only a few sellers the pricing and production

decisions (strategies) of any one firm will affect
overall industry price and production levels, and
hence the performance of other firms: a strategic
interaction.

each firm faces a demand curve with < ;

so they will set P > MC, and the resulting

PCMs will help defray the FCs.

If P > AC, then (economic) profits are positive.
New entrepreneurs will be attracted to enter.
Their entry will reduce P and erode market

share, until profits are zero.

For any of the firms, the result will be:

$/unit

..
...
.
... D
D
..
...
.
.
...
.
....
.. AC
.
.
..
....
..
.....
.
.. ...
.
.....
.. ....
.......
..
.. ....
........ ...
......
............
. ....
........
... ......................... D
. .....
.
.
.
.......... .........
...............
.........
.....
D

output/period
Monopolistic Competition

Many models of oligopolistic firm behaviour (see

Lectures 4 and 5).

3.2.3.1 Cournot quantity competition

Two companies produce identical output and so
must charge identical price P.
They jointly facing a linear industry demand curve
of
P = 10 Q,
where Q is the sum of the two companies outputs,
Q = Q 1 + Q 2.
The two companies have identical and constant
unit costs, AC = MC = $1/unit.
How much will each firm produce? Depends on
what each expects the other to produce.
As Cournot oligopolists, each chooses an amount of
output to maximise its profit, on the assumption
that the other is doing likewise: they are not
colluding, but competing. They choose
simultaneously.

R.E. Marks

ECL 3-29

A Cournot equilibrium is two outputs Q *1 and Q *2

and a price P* that satisfy:
1.

P* clears the market: P* = 10 Q *1 Q *2 ,

2.

Q *1 is Firm 1s optimal output given that is

expects Firm 2 will choose Q *2 , and

3.

vice versa for Firm 2.

That is, each firms expectation about its rivals

output is fulfilled and correct.
Firm 1 determines Firm 2s reaction function:
If I were Firm 2, Id choose my output Q *2 to
maximise my Firm 2 profit conditional on the
expectation that Firm 1 produced output of Q e1 .
Firm 2s profit = Firm 2s TR Firm 2s TC,
max 2 = (10 Q 2 Q e1 ) Q 2 Q 2
Q2

Thus Q *2 = 12 (9 Q e1 ), which is Firm 2s reaction

function as a function of its expectation of what
Firm 1 will produce (Q e1 ).
Since the two firms are identical, Firm 1s reaction
function is
Q *1 = 12 (9 Q e2 ).
Only one pair of outputs is simultaneously the
best response to each other: where the firms
reaction functions intersect,
at Q *1 = Q e1 = Q *2 = Q e2 = 3 units.
So Q* = 6 units, price P is then $4/unit, and the
profit of each firm is $9.

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ECL 3-30

Besankos Table 8.5 shows that the firms need not

be omniscient: trial-and-error adjustment will
converge to the equilibrium above.
In the Cournot model of quantity competition,
industry profit is not maximised: here Total Profit
= $18, but Monopoly Profit = $20.25. (See Table
below.)
As the number of firms in an industry with
quantity competition increases, price and profits
(both per-firm and industry) fall, and industry
output rises (see Besanko Table 8.6).
The average PCM of a firm in a Cournot
equilibrium given by
_H.I.
___
PCM =

The less concentrated the industry, the smaller

the equilibrium PCMs.

R.E. Marks

ECL 3-31

R.E. Marks

ECL 3-32

Case: The Corn Wet Milling Industry

3.2.3.2 Bertrand price competition

Until the 1960s a stable oligopoly, in which firms

convert corn (maize) into corn starch and corn
syrup, when several entrants appeared. Prices
driven down, but by the early 1970s, as capacity
utilisation rates and prices rose, competitive
stability returned.

Each firm sets a price and stands ready to meet all

the demand for its product at that price.

In 1972 came commercial high-fructose corn syrup

(HFCS): firms had to decide whether and how to
add capacity to supply the expected demand.
Eleven major competitors modelled as conjecturing
about overall expansion of industry capacity,
demand, and sugar (substitute) prices: analogous
to the Cournot model.
Modelled a fulfilled-expectation expansion path:
when each firm made its optimal capacity decision
based on its expectations of the industry path,
which did then actually occur.
The model predicted a moderate amount of
additional capacity, which was quite close to the
historical path.

Its price is set to maximise its profit, given that it

believes its rivals will do likewise.
The only equilibrium (where there is no incentive
to undercut the other firm) is where each is selling
at P 1 = P 2 = MC 1 = MC 2 = $1/unit. This is
identical to the competitive, price-taking case.
If MC 1 is greater than MC 2 , then Firm 2 will
capture the whole market at a price just below
MC 1 , and will make a positive profit; Q 1 = 0.
The firms outputs are perfect substitutes, which
intensifies competition.
Unstable, fierce competition is possible where:
FC are high, or
where there are capacity constraints

See Lecture 5.

R.E. Marks

ECL 3-33

3.2.3.3 Why are Cournot and Bertrand different?

Cournot can be thought of as choosing capacities
first, and then competing as price setters.
With Cournot quantity competition, prices adjust
more quickly than do quantities, which suggests
high costs of inventory holdings.
With Cournot, rivals set prices less aggressively
than in Bertrand price competition, since they
expect that any price cut will be immediately
matched.
With Bertrand, capacity is sufficiently flexible that
any demand can be matched.
With Bertrand, rivals expected to be able to steal
business.
See Lectures 4 and 5 for oligopolistic competition:
over quality,
over availability,
over advertising, and
where firms are ignorant of their rivals

choices, and
where timing is influential.

R.E. Marks

ECL 3-34

3.2.3.4 Bertrand price competition with horizontal

differentiation
When firms produce products that are close, but
not perfect, substitutes, then it can be shown that
equilibrium prices (with Bertrand price
competition) are well above MC. Product
differentiation softens price competition.

R.E. Marks

ECL 3-35

3.2.4 Monopoly
Monopoly power: the ability to act in an
unconstrained way.
A monopolist is a single seller; a monopsonist is
a single buyer.
Monopolies impose inefficiencies on society (see
Lecture 1-29 to 1-31), but if they arise when a firm
discovers a more efficient way of manufacturing a
product, or creates a new product that fulfills
unmet consumer needs, then consumers benefit.
Since innovation is risky, it will only occur if firms
believe they can earn high profits if they succeed.
In these cases, restrictions on monopoly profits
may prove costly in the long run. Patents provide
temporary monopolies.
Consider our two firms jointly facing a linear
industry demand curve of P = 10 Q, where Q is
the sum of the two companies outputs,
Q = Q 1 + Q 2.
They can collude and act as a monopolistic cartel.
They each produce half of the monopolists output
and receive half the monopolists profit.

R.E. Marks

ECL 3-36

From Lecture 1-23, the monopolists output QM is

such that MR (QM ) = MC = $1/unit.
From Lecture 1-20, since the demand curve is
linear, the MR curve is given by MR = 10 2Q,
which results in QM = 4.5 units, PM = $5.5/unit,
and M = (5.5 1)4.5 = $20.25.
So each produces output Q 1 = Q 2 = 2.25 units,
and earns 1 = 2 = $10.125 profit.
We can show the results in a Table and a Figure:
1
Q2
2
P
Q
Q1
_________________________________________________________
Price-taking 4.5
0
4.5
0
1
9
Cartel
2.25 10.125 2.25 10.125 5.5
4.5
Cournot
3
9
3
9
4
6
Stackelberg
4.5
10.125 2.25
5.063 3.25 6.75
Bertrand
4.5
0
4.5
0
1
9
_
________________________________________________________

(Stackelberg refers to quantity leadership, in this

case by Firm 1, that we discuss in Lecture 5.)

R.E. Marks

ECL 3-37

R.E. Marks

ECL 3-38

3.3 Evidence on Structure & Performance

10

Is market structure related to the level of prices

and profitability that prevail in a market, as
suggested above?

P = 10 Q

3.3.1 Price & concentration

6
$/unit

Monopoly

Cartel

Cournot

Stackelberg

Price-taking
MC = AC = 1

2
4
6
8
10
Quantity Q = Q 1 + Q 2

8
Q1 = Q2
6
Price-taking

& Bertrand

Cournot

2
0

But price-cost margins may vary across markets

for other reasons (which must be controlled for):
regulation,
product differentiation,
the nature of the sales transactions,
the concentration of buyers.

10

Q2

Compare price-cost margins across markets with

different structure, to avoid the difficulty of
different cost structures.

Cartel

Stackelberg

4
6
8
Quantity Q 1

10

From Lecture 1-23, want the ratio of P to MC, but

accounting cost data may provide only AC, not
MC; moreover, definition of costs may be
industry-specific.
Focus on industry-specific studies to assess the
relationship between concentration and price:
geographically separate markets with different
numbers of sellers.

R.E. Marks

ECL 3-39

R.E. Marks

ECL 3-40

With few exception, prices tend to be higher in

concentrated markets, and can be substantial.

Case: Price & Concentration in Local Hospital

Markets

e.g. when top three retailers had 60% of the

gasoline market, prices were about 5% higher than
when they had only 50%.

Does competition in health care markets result in

lower or higher prices?

In U.S. states that banned price advertising for

such professional services as spectacles and
retail chemists prices, prices were higher than in
states which allowed price advertising.

In the 1970 and early 1980s in the U.S.,

competition did not appear to reduce health care
prices as happens in other markets; but recent
studies suggest that both prices and costs are
reduced with competition.

How many firms must be in a market for price to

approach competitive levels?

Previously, choice of hospital was made by

patients and their doctors;

Once there are three sellers in a market, price

competition does not increase with more sellers:
its as intense as it can get.

not well informed about prices, and

with insurance they were not concerned about

prices.
Low competitive pressures.
Recently, purchasing power has shifted from
individual patients and their doctors to employers,
Health Maintenance Organizations, and insurers.
Motivated shoppers: keep savings.
Skillful shoppers: much data.

Especially in markets with empty beds (excess

capacity), such factors have held down the rate of
growth in hospitals prices and costs.

R.E. Marks

ECL 3-41

3.3.2 Other studies of determinants of profitability

Lecture 2 considered the link between economies
of scale (EOS) and market structure. Here, we
have considered the link between market
structure, competition, and profitability
(performance).
Together, a link between EOS and profits.
These theoretical links have been confirmed:
consistently, the same industries tend to be highly
concentrated in all countries, which suggests that
something like EOS determines market structure
in all markets.
Industries in which the MES of production is large
relative to the size of the market tend to be more
concentrated than industries with low EOS.

R.E. Marks

ECL 3-42

Difficult, however, to demonstrate the link

between concentration and profitability:
comparing accounting profits across industries

with different accounting conventions;

if an industry were truly profitable, then entry

would occur;
or few firms may be a result of low profitability

Or examine the relationship between profits and

EOS that might limit entry:
EOS in production processes as reflected in

large capital-to-sales ratios

EOS in marketing as reflected in large

advertising-to-sales ratios
In most cases, industry profits are higher when
there are EOS: consistent with the notion that
profits are high when industries are concentrated
because entry is difficult.

R.E. Marks

ECL 3-43

CONTENTS
3. Market Structure and Competition . . . . . . . . . . .
3.1 Market Structure
. . . . . . . . . . . . . . .
3.1.1 Market definition
2
3.1.1.1 Qualitative approaches:
2
3.1.1.2 Quantitative approaches to defining markets &
identifying competitors
5
3.1.1.2.1 Demand elasticities
5
3.1.1.2.2 Residual demand analysis
8
3.1.1.2.3 Price correlations
9
3.1.1.2.4 Trade flows 10
3.1.1.2.5 Other approaches 11
3.1.2 Measuring market structure 14
3.2 Linking Market Structure & Competition . . . . . . .
3.2.1 Perfect competition 18
3.2.1.1 Many sellers 20
3.2.1.2 Homogeneous product 22
3.2.1.3 Excess capacity 23
3.2.2 Monopolistic competition 25
3.2.2.1 Graphical depiction 26
3.2.2.2 Entry 27
3.2.3 Oligopoly 28
3.2.3.1 Cournot quantity competition 28
3.2.3.2 Bertrand price competition 32
3.2.3.3 Why are Cournot and Bertrand different? 33
3.2.3.4 Bertrand price competition with horizontal
differentiation 34
3.2.4 Monopoly 35
3.3 Evidence on Structure & Performance
. . . . . . . .
3.3.1 Price & concentration 38
3.3.2 Other studies of determinants of profitability 41

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.
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1
2

16

38