Lecture 1

• Perfect Competition as the industry benchmark


  • Large number of firms each of which has no market power
  • Homogenous products
  • LRAC is small in relation to market demand
  • All firms are 'price takers'
• Perfect Competition as the industry benchmark


  • Perfect information among consumers and producers
  • Exit and entry are costless
  • Firms maximise profits subject to given cost conditions
  • There is no competition in perfect competition
• P = MC in a perfectly competitive industry
• Allocative efficiency


  The price that consumers pay for one unit of a product is equal to the marginal cost of production
• Allocative efficiency is a 'first best' outcome because it maximises social welfare
• Allocative efficiency is a fundamental requirement of Pareto efficiency
• Only perfectly competitive industries automatically generate the P = MC outcome
• P = MC means that firms only earn 'normal profits' and there is no economic rent
• Lerner index


  Fundamental concept in analysis of industries,

  P-MC/p = 1/n

  where the term on the lhs is the price-cost markup, and the term on the rhs is the inverse of price elasticity of demand

  n = dQ/dP . P/Q

  note: slope only partly determines n
• Interpretation of learner index: price cost mark-up (determined by industry structure), is a function of price elasticity of demand

  The Lerner index ranges from 0 to 1
• In a perfectly competitive industry, the Lerner index = 0
• In a pure monopoly, the Lerner index = 1
• Structure-Conduct-Performance paradigm


  • Simple model: S → C → P, with uni-directional causality
  • Structure: How concentrated is the industry?
  • Conduct: Profit maximisation
  • Performance: P = MC (allocative efficiency), productive efficiency, R&D
• The 'simple' SCP model only makes sense when causation is unidirectional
• CR5, CR3


  Concentration ratios that measure the market share of the five and three biggest firms, respectively
• CR5 and CR3 only include the biggest firms and do not take account of differences in the shares of the 'N' biggest firms
• Concentration measure


  Needs to take account of: 1. Number of firms (N), 2. Inequality in market shares (I), C = c (N, I)
• Industry A


  • The 5 biggest firms account for 100% of the market, and all firms have equal shares
• Industry B


  • 10 firms, but the biggest firm is 10x the size of the smallest (0.5 v. 0.05)
• Industry C


  • 10 firms, CR5 = 80%
• Industry D


  • 10 firms, CR5 = 50%
• In terms of competitive strategy, industries A and D are likely to be the most competitive, while industry B is likely to be the least competitive
• Herfindahl-Hirschman Index (HHI)


  Where N is the total number of firms in the industry, and the share of each firm is squared, and this is summed for all firms
• A pure monopoly has an HHI = 1
• The minimum value of the HHI is 1/N, which means all N firms in the industry have identical market shares
• Using HHI, the rank order of industry concentration is: B (0.28), A (0.2), C (0.13), and D (0.1)
• One disadvantage of the HHI is that it requires firm level data for all firms, which is very difficult/impossible to obtain
• Simple model


  • Offers clear guidance to policy makers
  • Competitive industries are 'good' for social welfare
  • Concentrated industries are 'bad' for social welfare
• Alternative specifications of SCP


  • Do not yield clear guidance
  • Requires trade-offs
  • Possibly acceptance of second-best outcomes
• Monotonically decreasing average costs

  Larger firms have an absolute cost advantage, so 'natural monopolies'
• Trade-off between


  Allocative efficiency and productive efficiency
• Government intervention on pricing
• Asymmetric information
• Concentration measure (1)


  CR, or CR3, which measure the market share of the five and three biggest firms, respectively
• In empirical economics, it is common to use CRs, or CR3, which measure the market share of the five and three biggest firms, respectively
• Standard Industrial Classification (SIC) entries


  In the UK
• This metric only includes the biggest firms and, more importantly, it does not take account of differences in the shares of the 'N' biggest firms
• Note: we are interested in industry concentration, not aggregate concentration