L1 - IO: SCP and neoclassical theory

Question 1

What are the assumptions of the SCP?

Answer 1

Structural characteristics of markets change slowly, and can be considered fixed in the short run

The structure of a market influences the conduct of the firms operating in the market, which in turn influences the performance of these firms

The performance of the firm, in turn, potentially influences market structure

Question 2

Why is the SCP paradigm useful?

Answer 2

Allows the researcher to reduce all industry data into meaningful categories (structure, conduct, performance)

It is consistent with the neoclassical theory of the firm, which also assumes there is a direct link between market structure, and firm conduct and performance, without overtly recognizing this link

Useful for policy analysis

Question 3

How does the Chicago school perceive the SCP ?

Answer 3

The Chicago school argues the other way around - the arrows go the other way

Question 4

What is included in structure?

Answer 4

Structure: Entry and exit conditions, Product differentiation, Vertical integration and diversification

Question 5

What is meant by conduct and what does it include?

Answer 5

Conduct - the behaviour of firms, conditioned by the industry’s structural characteristics

Conduct: business objectives, pricing policies, product design, branding, advertising and marketing, R&D, collusion and merger

Question 6

What is included in performance?

Answer 6

Profitability, growth and quality of products and service. Also includes technological progress (productive efficiency and allocative efficiency)

Question 7

How does the neoclassical theory and the Chicago and Austrian school and Schumpeter differ in their views on profitability?

Answer 7

The neoclassical theory - assumes that high or abnormal profits are the result of the abuse of market power by incumbent firms

The Chicago school - abnormal profit may be the consequence of cost advantages or superior productive efficiency on the part of certain firms, which have consequently been able to achieve monopoly status by cutting price and driving rivals out of business.

Schumpeterian and Austrian views - abnormal profit is a reward for successful past innovation, or the exercise of superior foresight or awareness by an entrepreneur

Question 8

What is productive/ allocative efficiency?

Answer 8

Productive efficiency - the extent to which a firm achieves the maximum technologically feasible output from a given combination of inputs, and whether it chooses the most cost-effective combination of inputs to produce a given level of output.

Allocative efficiency - whether social welfare is maximised at the market equilibrium.

Question 9

What is the role of government policy (in terms of SCP)?

Answer 9

Government policy can shape structure, conduct and performance variables. There is a role for government or regulatory intervention to promote competition and prevent abuse of market power, if there is
high seller concentration in the market

Question 10

How can the government promote competition and prevent the abuse of market power (and do the measures affect structure, conduct or performance)?

Answer 10

Promote competition by preventing horizontal mergers or breaking up larger firms – structure

Impose price controls, legal restrictions on unlawful or acceptable forms of collusions – conduct

Adjust economic, environmental and social policies – performance

Question 11

Why does the Chicago school argue against government intervention?

Answer 11

Large firms are likely to have become large as a result of having operated efficiently, and therefore more profitably, than their smaller counterparts. Therefore, punishing the
largest firms because they are also the most profitable firms is tantamount to punishing success.

Chicago school: markets have natural tendency to revert to competition

Question 12

Name 6 critics of the SCP

Answer 12

Does not precisely specify the relationship between structure, conduct, and performance variables

It is often difficult to decide which variables belong to structure, which to conduct and which to performance.

What exactly do we mean by performance?

In practice, often difficult to define the relevant market or industry for analysis

Many of the variables in all three categories of structure, conduct and performance are difficult to measure empirically

In practice, hard to tell collusion and economies of scale apart: a positive association between concentration and profitability could arise

Question 13

What is new IO?

Answer 13

Focuses more on conduct and performance (as opposed to early IO approaches, including SCP, which focus on market structure)

Firms are active decision-makers, capable of implementing a wide range of diverse strategies.

Game theoretic approach to decision making under interdependence and uncertainty

Question 14

Contrast normal and abnormal profit

Answer 14

An economist would include in the firm’s cost functions an allowance for the reward the firm’s owners require to remain in business. This reward is known as normal profit. Finally, any additional return over and above the normal profit is known as abnormal profit.

Question 15

Is the law of diminishing returns a short-run or long-run concept?

Answer 15

Short-run

Question 16

How do internal economies of scale arise and what are the two types?

Answer 16

Due to firm expansion.

Real economies: Cost savings due to changes in quantities of inputs

Pecuniary economies: Cost savings due to changes in input prices

Question 17

How do external (dis)economies of scale arise?

Answer 17

Due to industry expansion (benefits accrue to all firms)

Diseconomies - Simultaneous expansion by several firms leads to shortage of
inputs and increased prices of factor inputs

Question 18

What are two types of internal diseconomies of scale?

Answer 18

Managerial diseconomies (Communication, organisational structure, industrial relations)

Transport diseconomies

Question 19

What are the four types of market structures?

Answer 19

1. Perfect competition
2. Monopolistic competition
3. Oligopoly
4. Monopoly

Question 20

What are the 6 main characteristics of a perfectly competitive industry?

Answer 20

1. Large number of buyers and sellers
2. Producers and consumers have perfect knowledge
3. Products sold are identical
4. Firms act independently of each other and aim to maximise profits
5. Firms are free to enter and exit
6. Firms can sell as much as they want at the current market price

Question 21

What are the assumptions of monopoly (6)?

Answer 21

One seller, large number of buyers, i.e. the firm’s demand function is the market demand function and the firm’s output decision determines the market price

Barriers to entry are insurmountable. If the monopolist earns an abnormal profit, there is no threat that entrants will be attracted into the industry.

The good or service produced and sold is unique, and there are no substitutes

The buyers and the seller may have perfect or imperfect information.

Geographical location could be the defining characteristic which gives the selling firm its monopoly position. In a spatial monopoly, transport costs are sufficiently high to prevent buyers from switching to alternative sellers located in other regions or countries.

The selling firm seeks to maximise its own profit.

Question 22

Compare efficiency and welfare properties of perfect competition
and monopoly

Answer 22

We assume constant returns to scale

With perfect competition - allocative efficiency as P = MC and firms produce at min of LRAC

Monopolist earns abnormal profit, companies in perfect competition earn normal profit

Question 23

How may a monopoly also be less desirable than perfect competition in terms of productive efficiency?

Answer 23

The lack of competition might make the monopolist lazy. Consequently, the monopolist may operate on a higher LRAC and LRMC function than it would attain if the full rigours of competition forced it to produce as efficiently as possible.

Question 24

Name 5 strengths of the neoclassical model

Answer 24

Theory uses tools of marginal analysis to make clear predictions about economic outcomes (i.e. observables in the data)

Gives clear testable implications and is suitable for normative analysis (see welfare comparison Monopoly vs. perfect competition)

In many situations the predictions of the neoclassical model actually perform very well

In that sense it is a useful theoretical benchmark to predict market outcomes

We should judge a model by whether the predictions help us understand the real world (the above)
In fact, Friedman (1953) argues: proper test of an assumption like profit maximization is not whether it is realistic but whether it enables us to obtain accurate predictions about observable outcomes (output, market prices, firm profits, etc.)

Question 25

Name 6 weaknesses of the neoclassical model

Answer 25

Because of its simplicity, the neoclassical model …

 . . . does not focus on internal decision-making within the firm (firm is a ’black-box’ represented by production/cost function)

 . . . assumes profit maximization as the solely objective in reality firms may pursue other goals

 . . . abstracts from uncertainty and imperfect information

 . . . abstracts from organizational complexity - larger firms may be more difficult to manage

 . . . assumes decision makers familiar with marginal revenue, cost and elasticity  - empirical evidence seems to indicate that businesses do not necessarily employ such methods

 . . . takes a static view of competition and unimportant role of entrepreneurship