CFA Level 1
Microeconomics - Types of Markets & Concentration Measures
Price Taker Markets
A purely competitive (price taker) market exists when the following conditions occur:
· Low entry and exit barriers - there are no restraints on firms entering or exiting the market
·Homogeneity of products - buyers can purchase the good from any seller and receive the same good
·Perfect knowledge about product quality, price and cost
·No single buyer or seller is large enough to influence the market price
Sellers must take the existing market price and they will adjust the quantity of their products so as to maximize profit at the market price. Because sellers must take the current market price, a purely competitive market also is called a "price takers" market.
Price-searcher markets are characterized by:
1.Barriers to Entry
2.Firms in the Markets that have Downward-Sloping Demand Curves
While perfectly competitive markets have a homogeneity of goods, price-searcher markets have a differentiation of goods. The differentiation could be in the form of location, taste, packaging, design, quality and many other factors. Some textbooks use the phrase "monopolistic competition" to describe markets where each firm has something unique about its product while facing significant competition. A good example would be a gas station. Although there are many competing gas stations, an individual gas station is the only one at its particular location and, therefore, to some degree it has a monopoly or is a sole seller. The CFA text prefers the term "competitive price searcher".
Firms in a price-searcher market with low barriers to entry have some flexibility to raise prices, as they will not lose all their customers if they do so. For example, if Valvoline raises the price of its motor oil, some people will be willing to pay the price for the motor oil they prefer. However, rival firms such as Pennzoil or Castrol also provide similar motor oils. As Valvoline raises its prices, many customers will switch to rival suppliers. The demand curve faced by firms in competitive price search markets, such as motor oil, will be highly elastic.
Firms in price-searcher markets with low barriers to entry face competition from existing suppliers and potential new entrants. If economic profits are being made in the market, then more firms will be expected to enter the market. Price searchers can set their prices, but the actual quantities sold will depend upon market forces.
Monopoly refers to a "single seller". The single seller will have a market with no well-defined substitute. The monopolist does not need to worry about the reactions of other firms. Utility companies are often monopolists in particular markets.
Concentration within an industry refers to the degree to which a small number of firms provide a major portion of the industry's total production. If concentration is low, then the industry is considered to be competitive. If the concentration is high, then the industry will be viewed as oligopolistic or monopolistic. Government agencies such as the U.S. Department of Justice examine concentration within an industry when deciding to approve potential mergers between industry firms.
The most common measure of concentration is the four-firm concentration ratio, which is defined as the percentage of the industry's output sold by the four largest firms. An industry with a four-firm concentration ratio of forty percent is generally considered to be competitive.
The Herfindahl-Hirschman Index (HHI) calculates concentration ratios by squaring the market share of the fifty largest firms in an industry. The formula can be expressed as follows:
HHI = s12 + s22 + s32 + ... + sn2
(where sn is the market share of the ith firm).
A monopoly would have the largest possible value - 1002 = 10000. The HHI for a highly fragmented industry would be close to zero. The Justice Department generally considers an industry with an HHI above 1800 to be highly concentrated.
Limitations of Concentration Measures
Concentration ratios have some of the following limitations:
· Foreign production – concentration ratios often fail to fully incorporate the revenue from foreign companies, thus overestimating the concentration of a domestic industry and underestimating the impact of foreign goods on competition.
· Ease of entry – an industry may have relatively few participants, but low barriers to entry. In such cases, a concentration ratio will overstate the power of current suppliers.
· Elasticity of demand – concentration ratios do not factor in the elasticity of demand and the availability of substitutes. Many highly-concentrated industries (metals, airlines, et al) are constrained by the availability and cost of substitute products and services.
· Imprecise definitions – a narrowly-defined industry will appear to be more concentrated than a more broadly-defined industry. Suppose we were looking at concentration within the shoe industry. Should the market be simply "shoes", or do we break that down further into "athletic shoes", "men's shoes", "children's shoes", etc.?
Coordinating Economic Activity
Economic activity can be coordinated by markets or by individual firms. A firm organizes input production factors so as to produce and market goods and/or services.
Auto manufacturers are actually assemblers of cars - most the parts in a car are produced by hundreds of component suppliers. This is an example of market coordination. If General Motors decides to coordinate all activities associated with brake components, then the coordination is being done by that firm. A firm will decide to coordinate a particular type of economic activity when it can do so more efficiently than what is provided by the market.
Firms can be more efficient than markets due to:
· Economies of scope - this applies when a firm hires specialized resources that can produce a broad range of goods and services. For example, a person with a difficult to diagnose medical condition would probably be sent to a hospital, which will have a broad range of medical specialists and diagnostic equipment.
· Economies of scale - for many types of goods, per unit production costs decline as larger volumes of output are produced by an individual firm.
· Team production can often lower production costs.
· Transaction costs are often reduced when economic activity is coordinated by a firm. Suppose you want to perform a major remodeling of your house. If you decide to coordinate the work yourself, you will have significant transaction costs associated with hiring qualified personnel such as plumbers and carpenters, monitoring their work, negotiating contracts with them, finding suitable building materials, arranging for delivery of materials and coordinating work schedules of the various subcontractors. If you hire a building firm or general contractor to coordinate the work, they probably will have lower transaction costs because they already will have knowledge of suitable subcontractors in the area and how best to get building materials. By hiring a general contractor, you will reduce your transaction costs by only having to negotiate one contract.
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