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IA-01. Competition According to Freshman Economics -- Market Concentration — Transcript

by Rich Makadok · 1,708 words · 310 segments · language en · Watch on YouTube

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0:04Our next topic in this course is
0:06industry analysis.
0:08First, why are we studying industry
0:11analysis at all? What's the point? I
0:14like to say that industry analysis is
0:17the Willie Sutton theory of strategy.
0:20For those of you who may not remember,
0:22Willie Sutton was a famous American bank
0:24robber in the 1930s.
0:26When the police finally arrested Willie,
0:29a newspaper reporter asked him, "Willie,
0:32why do you rob banks?" And Willie's
0:35classic response was, "Because that's
0:37where the money is."
0:39The same sort of logic underlies
0:42industry analysis. The idea is that
0:45there's more profit that you can gain
0:47with less effort or risk by anticipating
0:50what are going to be the most profitable
0:52markets to compete in.
0:54Uh it's like my dad always said, "If you
0:56want to be a leader, find a parade and
0:59get in front of it." That's the same
1:01sort of logic here. You want to find
1:03what's going to be the most profitable
1:04market to be in and get in front of it.
1:07You enter markets whose profitability
1:09you anticipate will increase, exit those
1:12markets whose profitability you
1:13anticipate will decline. And so, the key
1:16question in industry analysis is what
1:19drives the profitability of a market or
1:22industry?
1:24As a starting point for answering this
1:26question, let's do a quick refresher of
1:29some of the key points from basic
1:31freshman economics.
1:34In any introductory-level freshman
1:36economics 101 course,
1:39you learn three basic scenarios about
1:42how industries can behave.
1:45Each of these three scenarios are
1:46oversimplified, idealized models of how
1:49an industry can work.
1:52At the most competitive extreme,
1:54you learn about the idealized model of
1:56perfect competition.
1:59At the opposite extreme, the least
2:01competitive extreme, you learn about
2:04monopoly.
2:06In between these two extremes,
2:08you learn about oligopoly.
2:11Let's take a quick look at how
2:13industries behave under each of these
2:15three scenarios, starting with perfect
2:17competition.
2:18In perfect competition, there are
2:20numerous competitors with no predefined
2:23upper limit on the number of companies
2:25that can compete in the industry.
2:28And none of these competitors has any
2:30market power whatsoever.
2:33By this, I mean that no company has any
2:36control over the price that it can
2:38charge for its product or the price that
2:40it must pay for its supplies.
2:42Those prices, both for inputs purchased
2:45from suppliers and for outputs sold to
2:47customers, all of those prices are
2:50completely determined by the market and
2:52are totally outside the the company's
2:54control.
2:55In addition,
2:57all of the competing companies have
2:58identical products
3:00and companies can freely enter or exit
3:03the market at any time at no cost
3:05whatsoever.
3:07In the long run,
3:09free entry and exit would force all
3:11inefficient firms out of business
3:15so that the survivors would all share
3:18the same identical
3:20highly efficient cost structures.
3:25So, as a result of all these conditions,
3:28in the long run, perfect competition
3:31means that the price of the product will
3:33be competed down to the economic cost of
3:36producing it, leaving companies with
3:38zero economic profit.
3:41It also means that in such a perfectly
3:43competitive industry, society's scarce
3:46resources are used as efficiently as
3:49they possibly can be used to satisfy
3:51customers needs.
3:53Economists call that Pareto efficiency,
3:57which is a concept that's named after
3:58the famous Italian economist Vilfredo
4:01Pareto.
4:03Pareto efficiency just means that
4:05society as a whole benefits from perfect
4:07competition because society's scarce
4:10resources are put to their most
4:12efficient possible use in satisfying
4:15customers needs.
4:16This result, of course, is good for
4:18consumers and for society, but bad for
4:21companies.
4:25Now, at the opposite extreme, in a
4:27monopoly, there is only one company, the
4:30monopolist.
4:32That monopolist exerts tremendous market
4:35power.
4:36It can set its prices anywhere it wants
4:38to set them because customers have no
4:41other choice about where to buy the
4:42product. There's only one company
4:44selling it.
4:45So, the monopolist chooses its price to
4:48maximize its profit subject to the
4:51constraint that's imposed by the level
4:53of market demand at any given price.
4:56Also, there is no entry or exit in a
4:59monopoly. There is only one company in
5:01the industry, and in the future, there
5:03will only ever be that same one company
5:06in the industry.
5:08As a result of the monopolist's exercise
5:10of market power, it charges a
5:12substantially higher price than would be
5:15charged under perfect competition, and
5:17it thereby earns positive economic
5:19profits.
5:20We call these outcomes monopoly pricing
5:23and monopoly profits.
5:26Now, compared to perfect competition,
5:28this result, of course, is good for the
5:29monopolist, but bad for consumers.
5:33And it's also bad for society as a whole
5:36because the monopoly outcome is not
5:38Pareto efficient in the way that perfect
5:40competition is.
5:41This means that in a in a monopolistic
5:44industry, some of society's scarce
5:46resources are not being used as
5:48efficiently as they possibly could be
5:50used to satisfy customers needs.
5:53Economists refer to this inefficiency in
5:56the use of society's resources as a
5:58deadweight loss.
6:01So, there are two differences between
6:03the perfectly competitive outcome and
6:05the monopolistic outcome.
6:08Think about the benefits of economic
6:09exchange as a pie.
6:12When you compare monopoly to perfect
6:14competition, there's a difference in how
6:17it gets divided between companies and
6:19consumers.
6:20But, there is also a difference in the
6:22total size of the pie.
6:25Under perfect competition, consumers get
6:27the entire pie and companies get
6:30nothing.
6:32But, under monopoly, the monopolist gets
6:34a big slice of the pie.
6:36However, because of the deadweight loss
6:39that happens in monopolistic industries,
6:41the total size of the pie can be
6:43substantially larger under perfect
6:45competition than it is under monopoly.
6:49Okay.
6:50Oligopoly lies between the two extremes
6:53of perfect competition and monopoly. In
6:56oligopoly, there are a few competitors.
6:59But, what does a few mean?
7:01Well, it means at least two,
7:04but usually no more than five or six.
7:07We call these competitors oligopolists.
7:11So, what happens in an oligopoly?
7:14Well, the outcome of an oligopoly
7:17depends upon how the competing
7:19oligopolists react to each other.
7:22To explain how this works, economists
7:24have developed three different
7:26variations on the oligopoly scenario.
7:29Each of these variations is again an
7:31oversimplified idealized model of how an
7:34oligopoly might work.
7:36The first variation is called a Bertrand
7:39oligopoly, named after the French
7:41mathematician Joseph Bertrand.
7:44In a Bertrand oligopoly, the
7:46oligopolists compete with each other on
7:49price.
7:50The oligopolists choose their prices
7:53non-cooperatively,
7:55with each oligopolist guaranteeing to
7:57supply as much product as the market
7:59demands at the price it has chosen.
8:03The quantity of the output sold then
8:05adjusts so as to guarantee that the
8:07aggregate market supply is just exactly
8:10enough to satisfy the aggregate market
8:12demand.
8:14Now, the second variation on oligopoly
8:17is called a Cournot oligopoly, named
8:20after the French economist Augustin
8:22Cournot.
8:24In a Cournot oligopoly, the oligopolists
8:27compete with each other on quantity.
8:30The oligopolists choose their quantities
8:33of output non-cooperatively,
8:36with each oligopolist guaranteeing to
8:38sell that quantity of output at whatever
8:41price the market determines.
8:43The market price then adjusts so as to
8:46guarantee that the aggregate market
8:48supply is just exactly enough to satisfy
8:51the aggregate market demand.
8:55Finally, the third variation is a
8:58collusive oligopoly.
9:01In a collusive oligopoly, the
9:03oligopolists collude or cooperate with
9:06each other in order to select a price
9:09that maximizes their total joint profit
9:12among the entire group of oligopolists.
9:16So, how do these three variations on the
9:19oligopoly story differ in their
9:21outcomes?
9:22In the Bertrand variation, the
9:25oligopolists compete on price.
9:28And in the long run, that price
9:30competition winds up driving the price
9:32of their product down to the same level
9:35as we saw under perfect competition.
9:38All the way down to the economic cost of
9:40producing the product.
9:42So, as a result, under a Bertrand
9:45oligopoly, economic profits are driven
9:47down to zero. Which, like perfect
9:50competition, is good for consumers and
9:53good for the efficient use of society's
9:54scarce resources, but bad for the
9:57oligopolists.
9:59In a collusive oligopoly, the
10:01oligopolists cooperate in set in setting
10:04the price of the product. So, they set
10:06the price exactly where a monopolist
10:08would have set it.
10:10In effect, under collusion, the entire
10:13group of oligopolists behaves as if they
10:16were collectively a single monopolist.
10:20As a result, they charge monopoly prices
10:22and earn monopoly profits.
10:26This leads to the same deadweight loss
10:28as one would see under a monopoly.
10:31So, under a collusive oligopoly, the
10:33results are good for the oligopolists,
10:36but bad for the consumers and bad for
10:39the efficient use of society's scarce
10:40resources.
10:42Finally,
10:44the Cournot variation winds up being
10:46somewhere between the other two
10:48variations.
10:49The Cournot price winds up being higher
10:52than it would be under perfect
10:53competition, but not as high as it would
10:56be under monopoly.
10:58So, there is some monopoly profit and
11:01some deadweight loss, but not as much as
11:04there would be under a true monopoly.
11:07Exactly where the Cournot outcome lies
11:09between these two extremes depends upon
11:12the number of competitors.
11:14If there are very few competitors in a
11:16Cournot oligopoly,
11:18then the outcome can wind up being
11:19fairly close to the monopoly outcome.
11:22On the other hand, if there are many
11:24competitors in a Cournot oligopoly, then
11:26the outcome can wind up being fairly
11:28close to the perfectly competitive
11:30outcome.
11:31It would just depend
11:33on the number of competitors where you
11:35wound up in between those two extremes.
11:38So, in a nutshell, that is about as good
11:41a job as I can do to condense and
11:44simplify an entire semester of economics
11:47onto one slide.
11:51So, freshman economics teaches us that
11:55industries tend to be more profitable
11:57when there is less intense competition
11:59on price. And it also teaches us that
12:02the intensity of price competition tends
12:05to decrease when the market becomes more
12:08concentrated into the hands of fewer and
12:10larger competitors. So, the
12:13oversimplified and idealized models that
12:15you learn in freshman economics can
12:17leave you with the impression that
12:19market concentration is therefore the
12:22main factor, perhaps even the only
12:25factor that can affect the profitability
12:27of an industry.
12:28But, is that true? Is it all just driven
12:31by market concentration? Or are there
12:33also other factors at work, too?

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