Structure-Conduct-Performance
... The more concentrated or differentiated the industry is, the greater the firm’s pricing power that the ability to charge more than marginal cost, since there aren’t many good substitutes. Conduct is about what firms do to increase concentration or differentiation and how they exploit their resulting pricing power. Performance is about how well society allocates resources, by producing the right things in the right amounts, and it will depend on the power of price signals, which are distorted in highly concentrated or differentiated industries where firms have nearly monopolies. In the market structure, a firm’s output is relative to industry output. It’s an indicator of the competitiveness within the industry, if the industry is highly competitive, a lot of substitutes for the firm’s output exist, and the firm’s price elasticity is very high. If broader product categories have lower price elasticity (less substitutes) and the industry’s product is broader than a firm’s product. If the industry has few substitutes for a firm’s product, then the product will become differentiated, e.g. brand goods or different features and quality. Differentiation results from advertising, technology and sometimes time and location etc. Market structure (concentration) is itself affected by firms’ conduct (and hence by performance). That is because entry and exit of firms in the industry responds to how collusive or competitive firms are, what kind of entry barriers they create, how larger firms predate small firms etc. Entry and exit, in turn, affect market concentration. In others, both concentration & market power are determined endogenously, each affecting the other. Market power is directly related to market concentration and the strength of their relationship is affected by the elasticity of demand. If market demand is very elastic, changes in concentration won’t have very large effects on pricing and hence market power. If demand is very inelastic, changes in concentration can have big effects. Concentration of an industry depends on entry barriers and economies of scale or scope, which induce firms to merge and make it impossible for small, new entrants to compete on cost. In a concentrated and differentiated industry, firms will continuously strive to make the industry more concentrated and to differentiate their products through advertising or branding and research & development. Then, they take advantage of the favorable market structure by charging a high price so as to maximize profit margins. The correlation between concentration and market power need not always be positive. For example, the more collusive an industry is, higher the price and hence market power, but at the same time, higher prices and profits can attract new entry so that concentration may decline. So you would observe greater market power and smaller concentration. Finally, even if one does hypothetically observe that higher concentration always leads to market power, there remains an interpretation problem. The higher price firms charge the greater the firm’s mark-up over the marginal cost of producing a unit. While market structure and resulting pricing power determine how the firm can price, firm strategy influences how it actually does price. Long-term profit maximization doesn’t always imply maximizing short-term profit margins. A firm may operate under monopolistic competition, oligopoly, or monopoly and still price competitively for strategic reasons, e.g. introducing a new product, avoiding regulation, discouraging entry etc, or under pressure from aggressive competitors. Firms develop and adopt business practices (operations, marketing, finance, etc.) that support their positioning and competitive strategy. Activities and activity systems conducted within the scope of the firm must be carefully selected and nurtured if the firm is to successfully implement its value proposition. Performance of the firm is measured by firm’s profitability. Clearly, profits will be higher when the market structure is less competitive and the firm has pricing power. But from a total welfare standpoint, pricing power is bad because it induces firms to produce less than the optimal amount of output. If price exceeds marginal cost, the benefit of making another unit of that industry’s good exceeds the cost. After all, the price reflects consumer’s valuation of the marginal unit, so they wouldn’t pay more than it’s worth to them. But this means that additional surplus could be had by producing some more – up to the competitive level. Firms with pricing power will not stop producing, that’s because even though the total surplus isn’t maximized at that point, producer surplus is. Any further output would lower prices, and consumer surplus would grow even faster than total surplus, at the expense of producers. Firms stop when producer’s surplus is at maximum. This leads to “inferior” performance from society’s standpoint when firms have market power. The potential increase in social welfare can be achieved from expanding industry output. E.g. the government may regulate the industry that break up monopoly, reduce entry barriers. In a competitive industry, prices approach marginal costs, implying that price signals ushe...