Holdup Problem and Introduction to Market Structures Flashcards
Trade-off - Vertical Integration
Using market improves technical efficiency (least cost production)
• ! Vertical integration improves agency efficiency (coordination, transactions costs)
• ! Firms should “economise”:
! That is, choose the best possible combination of technical and agency efficiencies
Why Transaction Costs?
• If market mechanism improves efficiency, why do so many of the activities take place outside the price system? (Coase)
• Costs of using the market are saved by centralised direction - transactions costs
• Outsourcing entails costs of negotiating, writing and enforcing contracts etc.
○ Note:
• Transactions costs can occur inside (intrafirm) as well as outside/between (interfirm) [See: Williamson and after]
Other Sources of Transaction Costs
Investments that need to be made in relationship-specific assets
• Quasi-rents?
• Opportunistic behaviour after the investment is made (holdup problem)
Relation-Specific Assets
- Assets essential for a given transaction
- Can’t be redeployed for another transaction without incurring cost
- Once asset is in place, other party to the contract cannot be replaced without cost
○ Why?
§ Contracting parties locked into relationship to some degree (depends on renegotiation clause(s)) etc.
Different forms of relation-specific assets
- Site specificity (geography, clustering)
- Physical asset specificity (tech)
- Dedicated assets (specific buyer)
- Human asset specificity (knowledge, skills…learning)
- Others?
The Problem with Holdup
Holdup increases cost of transacting exchanges:
• Contract negotiations more difficult
• Investments may have to be made to improve ex-post bargaining position
• Potential holdup can cause distrust
• May be underinvestment in relationship- specific assets
Hold-Up Problem and Transaction Costs
Holdup potential may lead to investment in wasteful protective measures
• Manufacturer may acquire standby production facility for an input that is to be obtained from a market firm
• Floating power plants are used in place of traditional power plants to avoid site specific investments
Patent holdup
arise when circumstances enable a patent owner to extract a larger royalty ex post than it could have obtained in an arms length transaction ex ante.
Markets and Strategy
- If one firm’s strategic choice adversely affects performance another = competitors
- Firms may have competitors in several input and output markets at same time
- Competition can be either direct or indirect
How to Identify Competitors:
Intuitive:
○ ! Product performance characteristics
○ Occasions for use
○ ! Geography
• Data-driven:
○ ! Various metrics e.g. Cross-Price Elasticity of Demand
Market Structure
Markets described by degree of concentration
! Main approaches:
○ ! N-firm concentration ratio:
○ Herfindahl index:
N-firm concentration ratio:
Combined market share of largest N firms
○ Herfindahl index:
sum of squared market shares
now HHI with range 0-10000
Hirschman-Herfindahl Index (HHI)
○ used when assessing concentration levels to enforce U.S. antitrust laws.
○ HHI scores of less than 1,000 are thought to indicate an unconcentrated market with no competitor able to exert market power.
Sum of market share ^2 of own firm in the market
Perfect Competition
Price competition can be ‘fierce’ when two or more of the following conditions are met:
• Many sellers - costs below sector ave., collusion, cheating
• Customers perceive product homogenous - when lower price=buy more; new customers; switching from competitors
conditions:
- many sellers
- homogeneous products
- excess capacity
Monopoly
- Supernormal profit at MR=MC (P>MC)
- Genesis of monopolists (Demsetz) • Efficiency? (relative to competitors
- Create new products (meet unmet needs)
- Innovation - funded by profits, leads to (potential) benefit for consumers
Monopolistic Competition
Supernormal profit at MR=MC (where, P>AC) in SR
• Pricing at P=AC=AR (and at output MR=MC) in LR
• Many firms - not interdependent
• Products differentiated (heterogeneous):
○ Understand and develop this - v.imp in value creation and in Porter’s ‘Generic Strategies’
○ Combined with cost advantage -> Profit and market entry
Brands and loyalty - Strategic flexibility
Differentiation:
Vertical - distinct levels of quality
• Horizontal - differences across segments:
• Idiosyncratic differentiation - location and tastes which limit switching behaviour (to competitor)
Search Costs
cost of finding out about products:
• Low cost products=low differentiation=low search costs=low profit
Oligopoly
Key features:
Strategic interaction
• Number of firms (that strategically interact)
• Pricing & Output decisions affect market outcomes
Oligopoly
Models:
- Cournot (Quantity - Simultaneous)
* Bertrand (Price - Simultaneous)
* Stackelberg (Quantity - Sequential)
* Other e.g. Price Leadership (Price - Sequential)
Oligopoly
Reaction Functions:
Optimising (Profit Max. level, given other firm)
- Market-Clearing
- Other assumptions: Costs; Homogeneity of product.
Cournot Oligopoly
Special Case: Duopoly (homogenous)
• ! If two firms identical to begin with, outputs equal
• ! Each firm expects rival chooses Cournot equilibrium output
• ! If one firm is off equilibrium, both firms have to adjust their outputs
• ! Equilibrium = point where further adjustments not needed:
! Cournot equilibrium = Nash Equilibrium
• ! But, ‘revenue destruction’ (See: pp.174-5)
What about Bertrand Oligopoly?
Firms select the price and sell whatever quantity is demanded
• ! Each firm takes the price set by its rival as a given, and sets its own price to maximise its profits (reaction function)
! In equilibrium, each firm correctly predicts its rivals price decision
Bertrand Oligopoly
! Special Case: Duopoly (homogenous)
If firms are identical they will set the
same price as each other
! P=MC (same as perfect competition)
! Why? Otherwise each firm will have incentive to undercut the other
Bertrand Oligopoly
!Now: heterogeneous
When products of rival firms are differentiated, demand curves are different for each firm:
○ ! They are reaction functions
○ ! Equilibrium prices are different for each firm and > MC
○ ! Price cutting not as effective for stealing business
Oligopoly Models - Comparisons
Output adjusted quickly -> Bertrand
• ! Output cannot be increased quickly (capacity decision is made ahead of actual production) -> Cournot
• ! In Bertrand, min. of two firms sufficient to produce same outcome as infinite firms (Paradox!)
Market Structures - Causes?
Greater market concentration if:
○ ! larger the minimum efficient scale (MES) of production
○ ! If entry (exit) not easy
• !Monopolistic competition means easier entry and larger number of firms
Markets and Sunk Costs
Consumer goods markets seem to have a few large firms and many small firms
• ! Advertising costs or production costs (Sutton 2006)
! Advertising costs as endogenous sunk costs
• ! Early in the industry’s life cycle many small
firms compete
• ! Winners invest in brand name capital and grow
• ! Smaller firms can try to match investment and build their own brands or differentiate their products and seek niches
Markets and Price-Cost Margins
Theory predicts price-cost margins higher in industries with greater concentration ! But, variation in price-cost margins? • Regulation • Accounting practices • Concentration of buyers (monopsony)
Markets and Concentration
It is important to control for these extraneous factors to study the relation between concentration and price-cost margin
• ! Most studies focus on specific industries and compare geographically distinct markets
• ! For several industries, prices are found to be higher in markets with higher concentration
Empirical research continues, linking boundaries of firm and market structures:
! Scale and Scope and Structure
! Vertical boundaries and entry barriers
Vertical integration and innovation
