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VERTICAL RELATIONSHIPS

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									       Chapter 1                                                                                                                                                       1


CHAPTER 1   UNDERLYING INDUSTRY STRUCTURE IN
MEDIA REPORTING.
  SECTION 1. DIAGRAMMING THE VERTICAL RELATIONSHIPS AMONG MARKETS ..............................3
        upstream markets ........................................................................................................................................3
        downstream markets....................................................................................................................................3
        transfer prices ..............................................................................................................................................3
        factor market ................................................................................................................................................4
        product market ............................................................................................................................................4
  SECTION 2. TRANSMISSION OF SUPPLY AND DEMAND CHANGES THROUGH VERTICAL CHAINS ..6
    A. Supply in the Factor and Product Market..........................................................................................................7
    B. Derived Demand ..............................................................................................................................................7
        derived demand ............................................................................................................................................7
  SECTION 3. MARKET POWER IN VERTICAL RELATIONSHIPS .................................................................10
    MONOPOLY: ONE SELLER, MANY BUYERS ..............................................................................................11
    OLIGOPOLY: FEW SELLERS, MANY BUYERS ............................................................................................12
        interdependent ...........................................................................................................................................12
        competitive rivalry, ....................................................................................................................................12
  B. Conduct of Oligopoly.........................................................................................................................................12
        price war .....................................................................................................................................................13
        predatory pricing .......................................................................................................................................13
        Tacit collusion ............................................................................................................................................13
        Price leadership ..........................................................................................................................................13
        non-price competition ................................................................................................................................ 13
        contestable ..................................................................................................................................................14
    MONOPOLISTIC COMPETITION: MANY SELLERS, MANY BUYERS .....................................................14
        monopolistic competition ...........................................................................................................................14
    COMPETITION: MANY SELLERS, MANY BUYERS...................................................................................15
SECTION 6. COMPETITION. ...................................................................................................................................15
        competitive equilibrium .............................................................................................................................17
    MONOPSONY: MANY SELLERS, ONE BUYER............................................................................................17
        Monopsony ..................................................................................................................................................17
    BILATERAL MONOPOLY: ONE BUYER AND ONE SELLER .....................................................................17
    C. Bilateral Monopoly: One Buyer and One Seller ............................................................................................17
    OLIGOPSONY AND BILATERAL OLIGOPOLY: FEW BUYERS .................................................................18
    D. Oligopsony and Bilateral Oligopoly: Few Buyers .........................................................................................18
        oligopsonists................................................................................................................................................18
    E. Forecasting Performance ................................................................................................................................ 18
    Chapter 1                                                                                    2


CHAPTER 1   UNDERLYING INDUSTRY STRUCTURE IN
MEDIA REPORTING.
        Reporters often do not understand the significance of the information they provide in
media articles. It is up to us, the readers, to glean the information on markets. From a well
reported article we may be able to glean stories about what is happening in a market that the
reporters would never dream were there. We can create our own stories about what is happening
in a market, and these stories not only tell us what has happened in a market, but can help us to
project what will happen in a market.

         To understand a media article we must be able to classify what is happening in a market
in at least three ways:

       (1) the vertical relationships between organizations in the market,
       (2) the horizontal relationships between organizations in the market, and
       (3) the competitive behavior occurring in the market.

Figure 1-1 portrays the difference between vertical and horizontal relationships. A firm's
interactions with its buyers and its suppliers are called vertical relationships. Figure 1-1 shades
the two boxes representing the vertical relationships. Horizontal relationships concern firms
that can substitute for or complement each other’s production. For example, competitors in a
market are horizontally related. In Figure 1-1 two types of horizontal relationships are shown-
those that currently exist and those that potentially exist if competitors enter a market. These
horizontal relationships are both shown at the side of the center box which represent the
competitors in a given market. Competitive behavior exerts itself through the vertical and
horizontal relationships in a way that can be diagrammed.

Figure 1-1
      Chapter 1                                                                                 3



          FIVE COMPETITIVE FORCES
                            UPSTREAM MARKETS
             V                SUPPLIERS:
             E     Competitive forces
             R     through bargaining
             T     and economic leverage
         HOR I ZONTAL RELATIONSHIPS
             C
             A
 PRODUCERS                                                       POTENTIAL
             L COMPETITORS:
 OF SUBSTITUTES:
                            Competitive forces through rivalry   COMPETITORS:
 Competitive forces
                        R   of sellers in same market through    Competitive for ce
 through rivalry of
                        E   price, advertising, lobbying etc.    from threat of entry
 sellers in different
 markets through        L
 price, advertising,    A
 lobbying etc.          T        BUYERS:
                        I        Competitive forces
                        O        through bargaining
                        N        and economic leverage
                        S
                            DOWNSTREAM MARKETS

NOTE: Competitive forces exert themselves vertically through sellers and buyers as well as
horizontally.


SECTION 1. DIAGRAMMING THE VERTICAL RELATIONSHIPS AMONG
MARKETS

        To understand media stories, it is most important to sort out any vertical relationships
that exist between the players in a story. Beginning in the market for any good, there are two
directions to go to find vertically related markets. The vertically related upstream markets
consist of the factor markets which supply the resources used to produce the good. The vertically
related downstream markets consist of the product markets which consume or otherwise
transform the good. The good itself becomes a factor or resource for the downstream markets.
Vertically related markets should be characterized by:

(1)     Arms length transactions. The buyers and sellers should not be related to each other in
        any way. Otherwise the transaction is simply an in-house transfer, not an arms-length
        transfer between buyers and sellers. In-house transfers occur through transfer prices
        which do not necessarily reflect market prices or any relationship to cost; they often are
        determined by arbitrary policies within a firm.

(2)     Money transactions.      Transactions in markets generally should involve money
        transactions so that buyers and sellers can be determined. The seller in a transaction is
      Chapter 1                                                                                       4

        the party that provides the product or service. The buyer is the one who provides the
        money. With barter transactions, either product can be treated as money and therefore
        either party can be viewed as the buyer or seller. However, a vertical relationship
        establishes a clear direction for transactions for product (or service) and money to occur
        and sets out buyers and sellers.

(3)     Taking title. Everyone in a vertical relationship should own (take title) to the product or
        service they sell. Simply providing health insurance is not necessarily related vertically
        with hospital services; they may be complementary to each other if the buyer pays for
        both separately. However, health maintenance organizations (HMOs) often pay for the
        hospital services and then charge the customer for health services; taking title to the
        hospital service means that the HMO has a backward vertical relationship to hospitals and
        a forward vertical relationship to consumers.

A factor market is always immediately upstream from the product market. The resources in
the factor market should represent a cost to the product market. A higher price of the factor
should contribute to a higher price of the final product.

       Some media articles are complete enough to describe a chain of vertical relationships.
These chains can be constructed when a seller sells to a buyer who then turns around and
becomes a seller to another buyer who then turns around and becomes a seller to another buyer…
and so on. Some articles may involve very long chains of vertically related markets. The highest
upstream market in a vertical chain is a factor of production that can be classified as labor, land,
or capital. The lowest downstream market is the market after which a product or service
becomes extinct by being consumed either by household consumption, government purchase,
business investment, or export.

Why should a vertical chain be taken all the way up to the ultimate factors of production and
down to the ultimate consumers? Because the factor and final consumers are the ones who
       ultimately provide the resources upon which all of the players in media story depend
       ultimately provide the money upon which all of the players in the media story depend
       ultimately feel the impacts of any changes in the vertical chain.
Because the factor and final consumers are the ones who feel the ultimate impacts of any changes in
the vertical chain., one of the values of creating the chain is to see ultimately who is affected by the
media stories that we read. Furthermore, if there is a substantial lag in the speed with which
changes are transmitted through a vertical chain, it may be possible to predict changes that will
occur in the future to markets.

EXAMPLE: A Business Week article entitled "At Compaq, a Desktop Crystal Ball." (March 20,
1995, pp. 96-97) contained the following excerpts about the decision of Compaq to use older 486
computer chips for computers rather than the newer Pentium chips:
i.
       Chapter 1                                                                                     5

                 …Parides had persuaded his bosses at Compaq Computer Corp. to back a radical
         plan: Use complex simulation software to manage product introductions for the world's
         biggest PC maker. Parides' program was designed to model trends in customer demand,
         pricing, and even dealer inventories...
ii.
                 … As a result, it can simulate conditions such as component price changes,
         fluctuating demand for a given feature or price, and the impact of rival models. By
         modeling supplier and competitor behavior, the system lets managers consider the risk of
         certain actions before taking them.
iii.
                ...While rivals such as Dell Computer Corp. and Gateway 2000 Inc. were doing a
         booming business in Pentiums [a semiconductor chip], Compaq was amassing a huge
         inventory of PCs based on the older 486 [semiconductor] design. Compaq stuck to its plan,
         because the model said most corporate buyers wouldn't want Pentiums until early 1995.
         The gamble proved successful: Fourth-quarter earnings rose 61%.
iv.
                 ....He (Parides ran)... new scenarios and tweak(ed) the model to show the financial
         risks of moving up the announcement of Pentium PCs. The findings: Shifting too quickly
         to Pentium-based models would wreak havoc on pricing on Compaq's many 486-based
         units. It would also mean paying higher prices for new components than if it waited (Intel
         has since slashed Pentium prices).
v.
                For Compaq, which had often triumphed by bringing new technology to market as
         soon as possible, it was a tough call. "We bet against everything the company believed,"
         says Parides...
vi.
                 On Oct. 28, Parides and Sheehan found themselves before CEO Eckehard Pfeiffer....
         Pfeiffer, who listened intently, gave the pair all the assurance they needed. "It's about time
         we're doing these things," he said.

In this article, there are a confusing number of different players and markets which are shown in
bold letters as they are first mentioned. To sort them out, it is useful to group them by the
markets in which they are playing as follows:

PC makers (Compaq, Dell, Gateway 2000)*
Chips (pentiums, 486)
Corporate buyers*
Chip manufacturers (Intel)*

Such groupings of players often require careful reading of an article, particularly if a market is
unfamiliar to a reader.
     Chapter 1                                                                                                       6

         Next it is useful to check which of the groupings involve players (people or organizations),
which are starred in the above list and which are the markets (products, services, or markets). With
this information a vertical chain can be set up as shown in Figure 1-2:

                           Figure 1-2.


                   Participants             Markets
                  Labor
                                   Seller
                                            Labor Market
                                   Buyer
                  Chip Mfrs.
                                   Seller   Chips
                  PC Makers        Buyer    Corporate
                                   Seller   PC Market
                  CorporationsBuyer
                                   Seller   Goods & Svcs.
                  Consumers        Buyer




Although the article doesn’t mention a labor market that works for the chip manufacturers it is important to start with
a factor market. Although the article does not mention the final consumers of the goods and services produced by
corporations it is important to end with the markets that ultimately pay for the computers and chips. Why important?


        Consumers are the ones who ultimately pay for the computers. People employed by Intel
are crucial to the PC makers’ ability to provide computers. Both the consumers and Intel
employees are affected by the information in this article, even though they are not mentioned. To
understand the importance of media stories we have to guess who might be affected by them.
Establishing a complete vertical chain is a first step in seeing the full implications of a story.



SECTION 2. TRANSMISSION OF SUPPLY AND DEMAND CHANGES
THROUGH VERTICAL CHAINS

      Changes in a market in a vertical chain are transmitted up the chain to ultimate resources
and down the vertical chain to ultimate consumers. There are definite rules, rooted in the
determinants of demand and supply by which these changes occur.
    Chapter 1                                                                                    7

                           A. Supply in the Factor and Product Market

        If two markets are vertically related to each other, then their supply curves are closely
linked to each other. The supply curve for the factor shows the correspondence between different
factor prices and the quantities supplied of the factor. By contrast, the supply curve for a firm's
product shows the correspondence between different product prices and the quantities supplied of
the product. The two supply curves are related because the product market supply curve depends
upon the factor market. As taught in any course on the principles of Economics, factor prices are
determinants of supply for any product or service. Two guidelines result from this important
principle:
1.      A factor price change shifts all downstream supply curves in the same direction, ceteris
        paribus (everything else held constant).
2.      Anything that changes factor prices, including a change of demand in a factor market,
        will be transmitted through shifts in supply curves of all downstream markets.
Similar principles exist for demand.

                                       B. Derived Demand

        The concept of demand in the factor market can be formulated from information in the
product market. The demand in the factor market is a derived demand. In other words, the
demand for a factor depends on the demand for the product made from the factor. One of the
determinants of demand is “income” of buyers. When a firm is the buyers of a product then its
total revenue becomes the determinant of demand for the derived demand in upstream markets.
Two guidelines result from this important principle:
3.      A demand shift in a product market shifts all UPstream demand curves in the same
        direction, ceteris paribus (everything else held constant).
4.      Anything that shifts demand in the product market, including a change of supply in a
        product market, will be transmitted through shifts in demand curves in all UPstream
        markets.
These four guidelines allow us to trace the effects of competitive behavior through the vertical
chain. Following is the summary of basic rules of supply and demand transmission:
    Chapter 1                                                                                    8


RULES for VERTICAL DEMAND and SUPPLY SHIFTS
Determinants of supply and demand:
1. A higher price of resources shifts the supply
   curve upward.
2. A lower income of buyers (total revenue if firms are
   buyers) shifts demand downward.
Implications:
1. A demand shift causes a demand shift
     in the same direction for all upstream markets.
2. A supply shift causes a supply shift
    in the same direction for all downstream markets.
3. A change in price or quantity in any market translates
    into supply shifts in downstream markets.
4. A change in price or quantity in any market translates
    into demand shifts in upstream markets.

EXAMPLE: Using our vertical chain above, it is possible to follow the transmission of vertical
supply and demand effects. Let’s predict what the impact of Intel’s introduction of the Pentium
chip has on vertically related markets. As shown in Figure1-3 there are only four possible shifts
that can be caused by the introduction of a new product: (a) a shift upward (leftward) of the
supply curve, (b) a shift downward (rightward) of the supply curve, (c) a shift downward
(leftward) of the demand curve, or (d) a shift upward (rightward) of the demand curve.
        To determine which shift occurs, the party who is responsible for the event or the market
in which the event first occurs must be identified. If Intel makes the new product introduction
then both the labor market and chip market are initially affected. To indicate this initial effect,
we can circle the appropriate letter of the shift, as shown on the right hand side of Figure 1-4 In
the labor market where Intel is a BUYER, a demand shift must occur. As result of more
production, there is more demand for labor (shift “D” is circled). However, in the chip market
where Intel is a SUPPLIER, a supply shift must occur. As a result of more production, there is
more supply of chips (shift “B” is circled). By the first guideline, all downstream markets from
the chip market must experience a supply shift in the same direction. To indicate such secondary
transmission effects, an “X” is drawn through “B” for each of the downstream markets.
        Figure 1-3
      Chapter 1                                                                                                                         9



     Figure 1. Shifts of Supply and Demand
        (A)                                   (B)                            (C)                              (D)
 SUPPLY SHIFTS:                                                    DEMAND SHIFTS:
 LEFTWARD (up)                    RIGHTWARD (down)                 LEFTWARD (down)                    RIGHTWARD (up)

P               Supply            P                    Supply      P      Demand                      P      Demand




                        Q                                  Q                                   Q                                   Q


            Figure 1-4


     Participants Markets                                 Product         (m=many,f=few,1=one) Type of Market SHIFTS OF:
                                                          Differentiation SELLERS BUYERS (eg. Monopoly, SUPPLY DEMAND
                              I=international,N=national,
                                                          (Y= yes, N=no)                       competition,etc) Left Right Left Right
                              R=regional, L=local
    Labor
                         Seller
                                      Labor market
    Chip Mfr. (Intel)    Buyer         Extent: I N R L          Y Nm         f 1 m f 1        ___________        A B C D
                                   Chips (pentium,486)                                        Bilateral
                         Seller

                         Buyer
                                       Extent: I N R L          Y Nm         f 1 m f 1        Oligopoly
                                                                                              ___________        A B C D
    PC maker
                                      Corporate PC                                            Oligopoly
                         Seller
                                      market                    Y Nm         f 1 m f 1        ___________         B
                                                                                                                 AX C D
                         Buyer
    Corporate firms                    Extent: I N R L
                         Seller       goods & services
    Consumers                                                   Y Nm         f 1 m f 1        ___________         B
                                                                                                                 AX C D
                         Buyer
                                       Extent: I N R L
                                      Circle one for        Circle One Circle      Circle     Write down        Circle One of the
                                      each                             One         One        one market        four possibilities
                                      market
                                                                                              Type




Supply and demand shocks occurring in one market are transmitted through vertical relationships
    Chapter 1                                                                                      10

to other markets. A firm sees changes in its supply when its suppliers experience changes in
supply. This apparent truism is the mechanism by which cost changes are transmitted from seller
to buyer. Similarly, a firm sees changes in its demand when its customers experience changes in
demand. This apparent truism is the mechanism by which demand changes are transmitted from
buyer to seller.


SECTION 3. MARKET POWER IN VERTICAL RELATIONSHIPS

        Classification of markets provides an invaluable tool for predicting where market
disruptions are likely to occur in a vertical chain and formulating strategies making use of
vertical relationships. Every market in a vertical chain can be characterized as a particular type of
market. A full summary of the different market types appears in Figure 1-5

       Figure 1-5. Types of Markets

         TYPE OF MARKET PRD DIFF. SELLERS BUYERS
         MONOPOLY                        UNIQUE    ONE MANY
         OLIGOPOLY                       -         FEW MANY
         MONOPOLISTIC                    PRD DIFF. MANY MANY
           COMPETITION
         COMPETITION                     STANDARD MANY MANY
         MONOPSONY                       -        MANY ONE
         OLIGOPSONY                      -        MANY FEW
         BILATERAL
           MONOPOLY                      -                   ONE          ONE
         BILATERAL                                           ONE          FEW
           OLIGOPOLY                     -                   FEW          ONE
                                                             FEW          FEW
        Very little needs to be known to classify a market. Essentially all that is needed is
product differentiation, the number of sellers, and the number of buyers- information which is
often readily available in media articles. To determine if there is product differentiation of a
good or service we need only ask if we can recognize the specific firm that sells the good or
service. If such recognition is possible then there is product differentiation. This characteristic is
principally useful in distinguishing monopolistic competition from perfect competition.
Otherwise, the number of buyers and suppliers is the key for distinguishing the different types of
markets.
    Chapter 1                                                                                  11

        Once the type of market is known, then a great deal can be surmised about the behavior
and performance that can be expected in the market. . In Principles of Economics the models of
monopoly, oligopoly, monopolistic competition and competition are studied. In all three of these
models it is assumed that there are many buyers. However, when there is only one buyer or just a
few buyers, new market types can be distinguished. Each market type is characterized by certain
typical structure and behaviors:


MONOPOLY: ONE SELLER, MANY BUYERS

    Monopoly means that there is only one firm in a well defined market and there is no one to
compete away the profitability of that market. Monopolists have the freedom to produce any output
and charge any price within the constraint of market demand.

     The monopolist's freedom to choose does mean that complicated decisions must be made. Prices
cannot be pushed too low or raised too high without reducing profit. Top management concerns itself
with the science of coordinating its pricing and output decisions. Furthermore, the monopolist's high
visibility, high profitability, high prices, low output, and questionable efficiency can provoke
government intervention or even the entry of new competitors. Top management must prepare a
strategically balanced program involving marketing, controlled visibility and, even lobbying.
Nevertheless, a monopoly has room to recover from its mistakes, has the flexibility to achieve other
goals besides profit, and is under little pressure to change.

   The existence of only one firm and significant barriers-to-entry all have implications for
monopoly behavior:
1. Entry and exit. For a monopoly to survive, entry must be blockaded. The monopolist has an
   incentive to create and maintain barriers-to-entry. But protection from entry can breed
   complacency and stifle competitive instincts.
2. Legal tactics. Monopolists may sometimes lobby government organizations and the court
   system to enhance barriers-to-entry and its monopoly position.
3. Invention and innovation. Important instruments for maintaining a monopoly are research and
   development expenditures, patents, and copyrights. A monopolist receives the full benefit of any
   research that it does; no one else is in the market. However, without competition, there is little
   reason to incur costs and to turn inventions into innovations in the market place, as we saw with
   AT&T's lag in developing fiber optics (Chapter 8). A new technology may threaten employee
   jobs and the monopoly itself.
4. Marketing. Since the customer has no options, the monopolist has inadequate incentives to drive
   it to meet customer needs. Complacency often characterizes a monopolist's relationship with its
   customers.
5. Product and price strategy. Monopolists find it profitable to price too high and produce too little
   from society's point of view. While such a strategy may maximize profit in the short run, it
   creates the incentive for entry and may lead to lower long run profits.
    Chapter 1                                                                                      12

A monopolist's complacent conduct can itself have an impact on the long run future of monopoly.
Complacency makes the monopoly vulnerable to entry by more aggressive firms which will find a
way around barriers-to-entry. Many turn-of-the-century monopolies--in construction materials, foods,
fuels, and services long ago lost their monopoly power. Most monopolies today occur in utilities,
communications, local markets, and illegal markets, or are firms which own a unique resource or
location. But even in these markets, competition is knocking on the door.

        A monopolists economic profits may persist in the long run. And, efficiency is sacrificed in
the allocation of resources, choice of plant, and the utilization of plant. Price is higher, output lower,
and quality lower than what would have been expected from more competitive markets.
Government may perceive the inequities and welfare loss from monopoly and may intervene to break
up a monopoly as it did with AT&T.


OLIGOPOLY: FEW SELLERS, MANY BUYERS

     Many firms face a situation more akin to a battlefield than a market. A few interdependent
firms- in other words, firms can that affect each others' performance- slug it out in an oligopoly. The
objective of an oligopolist is often stated in terms of its market share- the percentage of total market
sales (or revenues) made by the firm. One firm's gain in market share is another firm's loss. To
further its market share goals, top management collects information on competitors, prepares a
"strategic game plan" for survival, and learns the art of decision making under uncertainty with
respect to its rival's plans. The interactions among a few important players can be so varied and
volatile that the oligopolists receive a disproportionate amount of news coverage. The oligopolist
faces a more aggressive, noisier environment than a monopolist.

     The structure, conduct and performance of oligopolies exhibit a wide variety of forms. While
many manufacturing markets are oligopolistic, the oligopolistic structure is not the predominant
structure of markets in the United States. In fact, executives in oligopolistic markets often
characterize their markets as competitive. However, while interdependent behavior is often referred
to as competitive rivalry, this is very different from the traditional economic concept of
competition.

    Many of the structural characteristics of oligopoly are similar to those of monopoly,and barriers-
to-entry originate from the same sources for monopoly. However, while barriers-to-entry blockade
entry in monopoly, entry is possible, though sometimes difficult, in oligopoly.

    The importance and interdependence of a few major players results in a variety of oligopoly
behavior, and economists have developed a wide variety of models to explain that behavior.
Oligopolistic conduct is marked by interdependence as firms maneuver for strategic advantage over
each other:

    (1)     Mergers and joint ventures: Given their interdependence it is in the oligopolists interest to
Chapter 1                                                                                    13

       cooperate and avoid intense rivalry. Since they are often barred from even informal
       cooperation due to antitrust considerations, they may resort to a formal organizational
       relationship with mergers or joint ventures.
(2)    Pricing Policy: In an oligopoly, firms are interdependent. A change in price may trigger a
       retaliatory response by competitors which shifts a firm's demand curve. A price war can
       erupt which results in retaliatory price moves that drive prices to levels at which some
       firms must exit. A dominant or powerful firm may deliberately employ predatory
       pricing to set prices below long run equilibrium levels to force weaker competitors out of
       the market and then to gain long run profit after they leave. Many oligopolies use limit
       pricing to keep prices low enough to forestall entry.1

               Such low profit outcomes provide an incentive to collude. The most overt form of
       collusion is conspiracy, which involves explicit agreements and planning among
       competitors concerning product pricing or the assignment of territories. Tacit collusion
       occurs when firms adopt a pattern of responding to each other in a market to fix price or
       output without consulting each other. Price leadership is a form of tacit collusion in
       which all of the firms follow a single firm in setting price.

               Over its history, an oligopoly may experience one form or a variety of forms of
       such interdependent pricing.

(3)    Product Policy: The interdependence among firms in an oligopoly means that firms react
       to their rivals' quantity, as well as price, decisions. Such interdependent reactions violate
       the ceteris paribus assumption required to measure a firm's demand. A firm may face a
       complicated, strategic pattern of demand shifts as competitors react to its price and
       product decisions.

(4)    Non-Price Competition: When firms are intensely interdependent, price changes become
       a powerful symbol of intentions. To avoid price wars, firms may avoid altering price and
       choose to compete in other ways. A firm may be able to enhance the quality, servicing,
       advertising, or delivery of a good without changing its price. Product improvements and
       product differentiation become an important source of non-price competition in
       oligopoly. As in price competition, rivals are likely to react when such non-price
       competition proves effective.

Interdependence requires careful consideration of the impacts on competitors and the reactions of
competitors to the use of any managerial tool available to a manager.

        Oligopolies suffer from some of the same problems as monopoly. The may choose
inefficient technologies. Nor does the oligopolist necessarily utilize its plant and capital
efficiently; barriers-to-entry may prevent the discipline that would force a firm to produce at the
minimum average cost. Allocative efficiency is not achieved because price exceeds marginal
cost. Price is still too high and production, therefore, is still too low. Economic profit can be
    Chapter 1                                                                                    14

    expected in the long run. Because of non-price competition, oligopolists are likely to perform
    better in customer-service and be more aggressive in pursuing technological change than
    monopoly.

            If there are firms waiting to enter the market, an oligopolistic market becomes a
    contestable market.2 If entry is easy, quick and efficient the threat of potential entrants can
    compel oligopolists to hold prices near the minimum of long run average cost. If so, the market
    is a perfectly contestable market and the oligopoly makes efficient capital choices, uses the
    capital efficiently, and uses other resources efficiently. Furthermore, the resulting lack of long
    run economic profit, the lower prices, and the high output levels mean the elimination of welfare
    losses.



MONOPOLISTIC COMPETITION: MANY SELLERS, MANY BUYERS

    There are many firms in truly competitive markets. And none of the firms have much- if any-
market power. Such markets are not the material for frequent dramatic headlines about big corporate
decisions on pricing or production, as in oligopolies or monopolies. Nevertheless, newspapers devote
whole sections to reporting the price performance (financial market data) and advertising (want ads)
for competitive markets, and these markets generate the largest part of employment and the gross
national product.

    Unlike oligopolies, competitive markets uniformly exhibit quite predictable structure, conduct
and performance. There are two different types of competitive markets, purely competitive and
monopolistically competitive markets. The difference between the two is determined by the nature of
the product. If customers cannot recognize which of many firms produce a specific good, then the
good is standardized and the firm has no ability to alter price. However, if the market is characterized
by product differentiation, then a firm may be able to gain some market power by building consumer
loyalty.    When there is product differentiation a competitive market is called monopolistic
competition.

    Product differentiation is the key characteristic which enables a market with many buyers and
many sellers to be classified as monopolistic competition. Product differentiation generally does not
become so strong that it becomes a formidable barrier-to-entry; there are too many firms and a large
variety of preferences to be met in the market place. Other barriers-to-entry are small or nonexistent.

     Product differentiation makes a market demand curve hard-if not impossible- to define; products
are not homogeneous and indistinguishable from each other. To the extent that a firm is successful in
creating product differentiation, it acquires a niche of loyal customers and the market power to alter
prices to those customers; the demand curve from the point of view of each firm is downward
sloping.
    Chapter 1                                                                                    15

    The only source of market power for monopolistic competitors is product differentiation.
Managers strive to differentiate their product and to build customer loyalty. To gain customer
loyalty, they develop marketing strategies, provide extra services, ensure quality, adopt the latest
techniques, and do everything possible to develop customer goodwill. Much of managements' time is
spent worrying about the image of their product, and copying the fads and successes of related
products.

     Since barriers-to-entry are low, one of the best indicators that a market is competitive is the
frequency with which entry and exit occur. With frequent entry and exit, monopolistically
competitive firms are less likely to engage much in the price wars, collusion, or other examples of
interdependent behavior that are so common in oligopoly. Any new entrant can undercut any deal
between existing firms, and success in eliminating one rival only results in a new entrant to take its
place.

      Whenever existing firms earn economic profit, the signal goes out to resource owners and
entrepreneurs to enter the market, driving the demand curves of existing firms further to the left. If
the demand curve is driven to the left of the long run average cost curve, exit occurs. In the long run,
the dynamics of entry and exit force monopolistically competitive firms to a price which equals long
run average cost.

     Customer loyalty allows firms to charge higher prices and different prices. When a market is
characterized by many different prices charged by many different firms it is probably monopolistic
competition. Customer loyalty also gives firms market power. With a downward sloping demand
curve the firms do not practice marginal cost pricing and therefore are not allocatively efficient and
are not likely to pick the most efficient investment choices.

    While the firm expects to produce profitably with its investment choices, entry of new firms
always prevents demand from being great enough to utilize capital most efficiently. Entry drives
economic profit TO zero in the long run even when profit is being maximized. There is chronic
excess capacity.

    When consumers choose greater variety, even in the face of the resulting higher prices, the
monopolistic competition model describes conduct and performance. In monopolistic competition,
consumers decide the tradeoff between efficiency and variety, in favor of variety.


COMPETITION: MANY SELLERS, MANY BUYERS

    Competition is not characterized by the complacency of monopoly or the interdependence and
aggressiveness of oligopoly.     Only when product is standardized can a market with many buyers
and sellers be considered purely competitive. Standardized product results in big differences in
conduct and performance than would occur with product differentiation in a monopolistically
competitive market. This one difference in structure means that managers find profit maximization is
    Chapter 1                                                                                    16

equivalent to cost minimization because they have no loyalty or market power. The single minded,
cost cutting mentality of competition is quite distinct from the goals and discretion of managers in
markets where market power can be exercised.

     Since firms in competitive markets have no market power, any hold that the competitive firm
tries to have on buyers can be washed away by the competition from the rest of the market. The
structural characteristics of the purely competitive market which prevent the development and
exercise of market power include:

    (1)    Large Number of Firms: When there are many firms in a market, the customer always
           has alternatives to a single firm's product or service.
    (2)    Low Barriers to Entry and Exit: Even when there are only a few firms in the market, the
           threat of entry and exit limits the price that a firm can charge. If entry is restricted then
           the market price does not fall enough to eliminate economic profit. If inefficient firms
           are not forced to exit, they continue to serve customers and make it harder for efficient
           firms to reach those customers. Both barriers-to-entry and barriers-to-exit must be low in
           order to allow the threat of entry and exit to establish discipline in the market.
    (3)    No transaction costs or restrictions on movement of resources: Customers have no
           transaction costs, lags, or difficulties in changing from one supplier to another. Similarly
           resources can be moved quickly and with low cost. Finally, companies can move in and
           out of the market with low cost as well. If resources are not mobile, then substantial lags
           and costs can prevent timely competitive entry into a market. If transactions costs are
           large, customers may simply be unwilling to change to more economical sources of
           supply. Furthermore, high transaction costs may prevent sellers from filling potentially
           profitable market niches.
    (4)    Standardized Product: The output of any one producer is functionally indistinguishable
           from that of any other producer.
    (5)    Perfect Information: Consumers can easily inform themselves about product prices.
           Resource sellers are well informed about alternative employment. Competitors can find
           out easily where economic profits are being earned and can use the least-cost technology
           to produce the product. These conditions allow entry and exit to be timely and efficient.
           No compromise in behavior is required due to competitive disadvantages in obtaining
           information. If information is not perfect, then entrants may not be able to learn the
           technology nor find out about opportunities.

    These structural characteristics eliminate a firm's pricing discretion; prices are determined by the
    market forces of supply and demand.

           Market supply and market demand determine the price in the market place. In the models
    of previous sections we have focused on a given firm's view of demand and average cost, with
    the implications for marginal revenue and marginal cost, because each firm had some discretion
    over the price it would charge. However, in a purely competitive market, the demand curve,
    from the point of view of a firm, is flat which means it is a price taker.
    Chapter 1                                                                                  17

           Although a competitive firm has no control over price, it does control how much output it
    produces. The fact that price remains constant regardless of how much the individual firm
    produces, means that a firm always knows precisely what marginal revenue is; it is equal to the
    market price. Because it produces up to the point where marginal cost equals price, a purely
    competitive firm is using marginal cost pricing. In pure competition marginal cost pricing is a
    simple, workable rule-of-thumb by which to maximize profit.

            Because firms enter and exit from the market, the market supply curve should shift until
    the competitive equilibrium is established. In other words, the equilibrium must occur where
    price just covers the minimum long run average cost for producing a good; where no further
    incentive for entry or exit exists. With price at the minimum of the long run average cost curve,
    very favorable performance can be expected from a market. There is no way to get price any
    lower without some firms being forced to exit from the market. Since price is forced to the
    lowest possible level, the quantity demanded is, similarly, as great as can be profitably supplied
    and product is efficiently provided. Finally, in the long run, the competitive firm earns only
    normal profits, which means zero economic profit.


MONOPSONY: MANY SELLERS, ONE BUYER

         When there are many sellers but only one buyer, the market can be described as a
monopsony. Buyers have market power when they can change market prices. When buyers have
market power, it is no longer adequate to examine the supply curve to find profit maximizing
output. The buyer has an impact on factor price. An additional purchase raises the price of all
factors purchased, not just the last unit purchased. A buyer must therefore must restrict
production to keep factor prices down and force prices down to the supply curve with every bit of
market power that it can muster. A buyer with market power therefore has an incentive to buy
less of the factor and to produce less output than if it were producing efficiently.

        There are many historic examples of monopsony. Typically when cultures expand into
new areas there are very few employers for labor. The one company towns of the westward
expansion in the United States were typical examples. For many defense related items, the
federal government is the sole buyer.



BILATERAL MONOPOLY: ONE BUYER AND ONE SELLER

        When there is only one buyer and only one seller, the market is characterized by bilateral
monopoly. Typically such markets mean that both the buyer and seller have market power.
When both buyer and seller have market power, price and output are indeterminate. In the
special case of bilateral monopoly in which there is only one buyer and one seller, both the
monopoly and the monopsony models apply. But together the two models do not provide a
    Chapter 1                                                                                  18

consistent solution. Both the buyer and the seller wish to restrict output. However, the seller
wants a price that is higher than the competitive price and the buyer wants to drive the price
lower than the competitive price. There is no definite outcome; it must be determined by
negotiation or arbitration.

        If the buyer and the seller can coordinate and agree about how to apportion profits, there
is a most profitable rate at which to produce. It occurs at the choice which would occur if the
market were competitive. If the buyer and the supplier are vertically integrated, they would find
that they could maximize their profits in the downstream market at this competitive solution.
However, when the buyer and seller are independent of each other, they may find negotiation
impossible over the way to apportion their joint profit using the factor price. They may end up
with an inferior joint profit position if either player can find a way to gain a superior profit
position for itself, such as the monopoly or monopsony position.3

        Bilateral monopolies require an inordinate amount of interference from political and legal
authorities because the market is continually threatened with breakdowns. The most familiar
bilateral monopoly circumstances occur in labor markets when unions face a unified management
negotiating team. But franchised businesses are also often bilateral monopolies with a
disproportionate amount of intervention from government.


OLIGOPSONY AND BILATERAL OLIGOPOLY: FEW BUYERS

        When there are several buyers and many sellers, the oligopsony model may apply. In
oligopsony, it may not even be possible to define a supply or marginal factor cost curve for a
buyer. Because of the interdependence among oligopsonists, a change in what one oligopsonist
pays for resources can result in retaliatory bidding from the other oligopsonists. In other words,
it is meaningless to define a supply curve because the responses of other oligopsonists cannot be
held constant; such a curve would shift with retaliatory bids for resources.

        If the outcome is difficult to determine in bilateral monopoly it is even harder to
determine in bilateral oligopoly where there are a few buyers and a few sellers and where the
strategies can become very complex. However, when bilateral monopoly or bilateral oligopoly
appear in a vertical chain, it may prove to be a bottleneck. When bargaining breaks down in such
a market, strikes, lockouts, injunctions, and political controversy may occur. Vertically related
markets can be disrupted.

        The structural classification of markets provides the basis for forecasts of performance
and market disruptions. Figure 1-5 provides the information to classify each of the markets in a
vertical chain. On the basis of the number of buyers and sellers in a market Figure 1-6 classifies
the possible types of markets and shows the corresponding performance which can be predicted
for each type of market in price and output. Finally, Figure 1-7 classifies the markets according
to the type of behavior and performance expected from each market.
     Chapter 1                                                                   19




                   Degrees of Market Power
    Type of        # of        # of       Output compared to Price compared to
    Market         buyers      sellers    competition        competition


    Perfect        many        many       -----              -----
    Competition
    Monopolistic   many        many       less               higher
    Competition
    Oligopoly      many        few        less & more        higfher &
                                          stable             more stable
    Monopoly       many        one        less               higher

    Oligopsony     few         many       less               lower

    Monopsony      one         many       less               lower

    Bilateral      few         few        less               indeterminate
    Oligopoly
    Bilateral      few         few        less               indeterminate
    Monopoly




                            Figure 1-5.



.
    Chapter 1                                                                                  20

NOTE: On the basis of the number of buyers and sellers it is possible to predict the price and
output performance in a market. Generally market power means less output than in perfect




                                   Figure 1-6

 TYPE OF MARKET                 OBJECTIVE P Q PRO- EFFI
                                              FIT CIENT
 MONOPOLY                       S.Run Profit           Large Not
 OLIGOPOLY                      Mkt. Share             Med. Not
  Interdependence               Horizontal W A R
 MONOPOLISTIC                   Customer               None Exc.
   COMPETITION                    Loyalty                   Cap.
 COMPETITION                    Min Cost Lowest HighestNone Yes
 MONOPSONY                      Min Price              Yes Not
 OLIGOPSONY                     Min Price               Yes Not
 BILATERAL                      Max Share ?          Vertical
   MONOPOLY                       of Profit             WAR
 BILATERAL                      Max Share ?          Vertical
   OLIGOPOLY                      of Profit             WAR

EXAMPLE: Even from the short quotation above about Compaq, there is enough information
tentatively to classify two of the markets in the vertical chain. The very fact that they name the
producers (Compaq, Dell, and Gateway 2000) suggests that they are important enough to affect
the market for computers; they may have market power. By contrast there is specific mention of
no single corporate buyer and barely a mention of the buyers of personal computers at all which
suggests there are many of them with little market power. With few sellers and many buyers the
corporate computer market might tentatively be classified as an oligopoly, as is shown in figure
1-4.
        By similar reasoning it is possible to classify the chip market. Only one firm, Intel, is
mentioned which could mean it is a monopoly. In this case the article is not providing enough
information to know that there are several other chip makers which might allow the market to be
    Chapter 1                                                                                 21

classified as an oligopoly. However, if there are only a few computer manufacturers, then it is
conceivable that the chip market is more like a bilateral oligopoly. The article is not providing
enough information for us to be sure of what type of market it is.

        If the chip market is a bilateral oligopoly as shown in figure 1-4, then we might predict
future market disruptions as the chip makers and computer manufacturers battle each other over
prices. Such predictions provide a point of departure for reading further articles on a market to
see if our predictions are confirmed.


1. A good example of the way to measure such behavior can be found in: Robert T. Masson &
Joseph Shaanan. "Excess Capacity and Limit Pricing: An Empirical Test" in Economica (August,
1986) pp.365-378


2. A clear, early presentation of the contestability concept can be found in William Baumol.
"Contestable Markets: An Uprising in the Theory of Industry Structure" in American Economic
Review, Vol. 72 #1, (March, 1982) pp. 1-15. To see a readable example of the way this concept
is used for policy purposes, see Steven A. Morrison and Clifford Winston. "Empirical
Implications and Tests of the Contestability Hypothesis" in Journal of Law and Economics, Vol.
XXX (April 1987) pp. 53-66

3. A major problem in exposition of bilateral monopoly has been found in many Economic
Principles textbooks in the following article:
        Roger D. Blair, David L. Kaserman, Richard E. Romano. "A Pedagogical Treatment of
        Bilateral Monopoly" in Southern Economic Journal, Vol. 55 No. 4 (April 1989) pp. 831-
        841
The article lays out clearly what can be said about bilateral monopoly and the source of the
indeterminacy in the model.

								
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