The criticism of the structure- conduct- performance approach comes from the work of W. J Baumol (1982) who introduced the concept of what he called a contestable market. They key link in the structure –conduct-performance view is link from seller concentration to market pricing behaviour of performance in terms of whether firms make profit in excess of normal. However Baumol wishes to argue that seller concentration is not significant in terms of the ability of a company to make profit above normal.Whether a firm can do that, depends not on seller concentration but on the degree of contestability of a market.
Contestability is the ease with which new firms can enter the market and the ease with which firms in the market can leave if they regard their performance as inadequate. The following are the characteristics of a contestable market •Firms action are influence by the threat of new entrant to the industry •There exist no barrier to entry and exit No sunk costs(costs that cannot be recovered when exiting the market) •Firms may intentionally limit profits made to discourage new entrants(entry limit pricing •Firms attempting to erect artificial barrier to entry, for example producing over capacity to flood the market and drive down price in the event of an entry threat, aggressive branding and marketing strategies to close up the market and also the possibility of predatory or destroyer pricing.In order to assess the idea that potential competition is an important influence on pricing behaviour, I will have to start looking at related market structures that inhabit market contestability and how they set prices due to their nature as a reaction of contestability or fear of competition. Perfect competition market structure can be viewed as some sort of theoretical construct that doesn’t exist in the real world. However the only sector in the economy that gets close to perfectly competitive markets is probably agriculture.Many farms are price takers and produce only a tiny fraction of the total supply of potatoes, milk, and egg and much more, for which they exist many buyers.
Fitting in with the characteristics of contestable markets, the product sold in this form of market is often homogeneous in character and entry barriers are minimal and also almost no sunk cost. Profit maximisation would seem to be a sensible and probably necessary objective if small farms are to survive.Due to the nature of this market structure, as earlier said with the example of agricultural products where many farms are price takers, therefore they have little or no control over the price they charge. ie perfect competition: •Firms have to take the price set by the market •Large number of sellers, each small market share and therefore no control over the market. Examples may include agricultural products, some type of financial product (stocks and shares).The case for perfect competition is an ideal market structure for the entire economy giving the rise to the possibility of Pareto optimal allocation of resources in society, such an allocation is said to exist when it is impossible to make one person better off without making another worse off at the same time.
To further explore the relationship between competition and price and the influence of potential competition on price, I will look at monopolistic competition; this theory was developed by Chamberlin (1933) it holds to market situation where large numbers of firms are selling similar but differentiated products.Competition would not only apply to the price charged but also to the quality of the product, advertising and sales promotion. The assumption of free entry and exit from the market as in the perfect competition still applies as compared to perfect competition each good is slightly different in composition or brand image. For instance, different brands of toothpaste or detergents are similar but identical to one another.
As a result each firm does not face a perfectly elastic price taker. One firm may charge a higher price than its rivals without losing all its customers due to brand loyalty for its product.Although supernormal profits are possible in the short run, because of free entry assumption, only normal profits will be made in the long run, because at the long run new firms will be attracted into the industry if short run super normal profit is being earned. The result of the new entry will be that each individual firm will be unable to operate at full capacity.
Average cost of production will not be minimised and therefore firms will be producing inefficiently. See appendix 1. 0 for further explanation.Another market structure that exhibits contestability is the oligopolistic market structure; most industries fit the definition of being oligopolistic in character. Oligopoly refers to a situation where there are few producers.
There is no longer complete freedom of entry in to the industry. Instead entry barriers exist and help to explain why only a few firms are present in this market. Supernormal profits can be earned in both short and long run. Do oligopolistic firms actively compete with one another to achieve their goals?The question of how oligopolistic responds to one another and also potential entrants hoping to enter their market, is viewed by many oligopolistic theories which range from collusion to price warfare. Oligopoly is a market situation in which firms realise that their actions are interdependent that is the change in the output by one firm will alter the profits of other firms, which will cause them to change their outputs. This reaction alters the first firms to alter their behaviour.
This recognised interdependence takes out the determinateness which characterises the polar cases of monopoly and perfect competition.Under monopoly and perfect competition industry output and price can be predicted if the firms cost curves and the industry demand curve is known. But this is not the case under oligopoly. This is because the important feature of oligopoly is not the number of firms in the industry but their interdependence though the number of firms may have some influence on the degree to which this interdependence is felt by the firms.
I will start by examining some of the main theories of oligopolistic behaviour. Traditional theories start with Cournot’s (1838) model. Each firm is assumed to seek profit maximisation taking its rivals output as given.This provides us with an apparent inconsistency with the notion of oligopolistic interdependence. In situation of disequilibrium rivals will surely respond by changing their output levels which will nullify the Cournot assumption.
G. M. Grossman and K. Rogoff (2005) Bertrand (1883) criticise the above theory where he suggested that rivals prices rather than output must be taken as given. This is consistent with later research into the theory of the kinked demand curves and rigid pricing where rivals are assumed not to respond to price increases, although they do respond to cuts.Heinrich Von Stackelberg (2011) Firms may react to interdependence by colluding, if public policy allows, and the most extreme form of collusion is joint profit maximisation in which total industry profits are maximised by the firm acting as a single monopolist.
However such a collusive solution is unlikely to be stable since each firm can increase it individual profits by cutting its price if the other firms abide by the collusive agreement. Industry price and output would be determined as for a multiple plant monopolist with each firm producing where its marginal cost is equal to industry marginal revenue.But if an individual firm cuts its price and expands its output to a point where its marginal cost is equal to its own marginal revenue then its own profit will increase provided other firms adhere to the collusive agreement. This hold true for all firms in the cartel and so the cartel will not persist unless it can deter cheaters and effective 1punishment. The theory asserts that the oligopolies wish to set a monopoly price but they are limited by the difficulty of detecting secret competitive manoeuvres by individual firms.
Stigler (1968 p. 1) Rather than attempting to maximise joint profits the members of a cartel may have the more limited aim of preventing entry into their industry to safeguard their existing profit levels. The bases of these theories are that a potential entrant will be deterred if he believes that the post-entry price will not cover his long-run average cost. Bain (1949) was the first to suggest that price is set below the profit maximising price in a number of highly concentrate industry to block the entry of potential competitors, the so called Bain-Sylos model of limiting pricing.Finally, an alternative approach to the analysis of the interdependence problem in oligopolistic decision making is game theory. The underlying assumption in zero-sum games (where one’s gain is another’s loss) is that firms are actively competing against one another rather than engaging in some form of collusion.
Businesses are assumed to be capable of calculating their optimal moves of the opposition and of preparing their own defensive measures accordingly. Game theory is a cautious approach to the problem since it’s assumed that the worst will happen namely that rivals will always use their best possible strategies against their rivals.Assume just two firms in the market, a duopoly, firm one has a decision to make as to whether to set a high price or a low price. It does not know whether the other firm is going to set a high price or a low price, what would make a difference would be if it could eliminate the uncertainty by knowing what firm two was going to do. If both can agree to set a high price, both gain, suppose this is not possible.
If one chooses a higher price and the other goes for low price the firm with the high price will lose enormously because consumer will switch out of the igh priced product. On maxi-min bases each chooses the low price and profit are less than they might have been. The problem that faces both firm is uncertainty, if they could eliminates these, they will certainly do better. How do they eliminate uncertainly? This is done by collusion or agreeing a price. Ken Heather (2002) Example for such a market condition is that of detergents.
Unilever and P&G (Procter & Gamble) The attributes of perfect competition have been applied to oligopolistic and monopolistic industries operating in perfectly contestable markets by Baumol (1982).The crucial feature of such markets is their vulnerability to hit and run entry. Because of free entry and exit, the monopolist or oligopolies may prevent entry only by behaving in perfectly competitive manner or otherwise face “hit and run” entry. When these markets are in a state of equilibrium price is set equal to marginal cost. Only normal profit will be earned and maximum efficiency in production will be achieved. Reference; Monopolistic Competition (2011).
Encyclop? dia Britannica Online. Retrieved 06 December, 2011, from http://www. britannica. om/EBchecked/topic/390037/monopolistic-competition Appendixes; Figure 1.
0 illustrates this result. P1 and Q1 are price and quantity in the long run for the firm. The minimum efficient size of firm would be at output Q2 on the figure where average cost is minimised at AC1. The distance P1 AC1 on the vertical axis is the gap between actual unit costs and minimum possible unit cost.
Hence the equilibrium size of firm is inefficiently small and only normal profits will be earned. Price is no longer equated at marginal cost as in perfect competition.Price is set higher than marginal cost at the long-run equilibrium output level, as seen from the figure 1. 0.
In this type of market environment there exist a dominant firm. This firm sets the price and that price will be match by all the small firms in the market, who will then, in the light of the price set by the dominant firm, decide how much output they will produce for example in the computer software industry, Microsoft is the biggest software producer and so set the price why the smaller software producers accept it. So it is a further support that, a potential competition will have an influence in price.
