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Managerial Economics

Managerial Economics. Lecture Six: Alternate models of markets. Recap. Conventional model of competition “taxonomic” Classifies industries as “competitive” on basis of number of firms & market shares Lots of firms/small share per firm: competitive “Price equal to marginal cost”

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Managerial Economics

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  1. Managerial Economics Lecture Six: Alternate models of markets

  2. Recap • Conventional model of competition “taxonomic” • Classifies industries as “competitive” on basis of number of firms & market shares • Lots of firms/small share per firm: competitive • “Price equal to marginal cost” • Few firms/large share per firm: non-competitive • “Price exceeds marginal cost”

  3. What is competition? • Problems • Taxonomy almost impossible to apply • Few industries clearly “competitive” or “non” • Most have few big firms, many small firms • Results in weird classifications • Computer industry “uncompetitive” • Computer manufacturing is industry 334111 in USA Manufacturing Census • Top 4 firms had 45.4% of market in 1997 (biggest IBM 9th biggest firm in USA; 2nd HP 11th biggest) • Top 8 68.5% • Top 20 92.9% • But also has rapidly falling prices, rising quality • Is it “uncompetitive”?

  4. What is competition? • Theory flawed anyway • Corrected theory finds no difference between “competitive” & “monopoly” outcomes • Both produce where Price > Marginal Cost • Real firms face constant or falling marginal cost anyway!

  5. How else to model markets? • One alternative: see competition as a process • Firms compete by differentiating products • Process over time reduces real price, increases quality • Characterisation as “competitive” comparative & based on process and outcomes • Process • whether firms enter/leave industry • whether products change over time • Outcomes • whether price/quality improve • Comparative: with respect to other industries

  6. The motivation • Many old monopolies/state enterprises being made “competitive” • Entry deregulated • Publicly owned assets privatised • Success of policy judged according to conventional economics: • IF many firms enter AND original monopolist loses dominance THEN competitive • “The market works” • ELSE IF new entrants fail and monopolist remains dominant THEN uncompetitive • “The monopolist is exploiting its power” • “Pro-competition” regulations used to control monopolist, force lower market share, etc.

  7. The motivation • BUT many “monopolists” complain • Have reduced prices/increased quality • Competition “fierce” • Failure of new entrants natural part of competition • Ormerod’s approach: produce computer model of industry with • Differentiated firms (offering different price/quality combinations) • Differentiated consumers (different price/quality tradeoffs) • See what evolves • IF instrumental outcome (price/quality) poor THEN industry “uncompetitive” • IF outcome good then “competitive” • Analyse correlation between standard taxonomic view of competition & instrumental view

  8. A “Schumpeterian” model of an industry • Conventional micro models competition with: • Homogeneous product • No quality differences between firms • No technical change • Quality & costs constant • Rising marginal costs and falling marginal revenue • Schumpeter emphasises • Differentiated products • Quality differences between firms too • Technical change • Driving force of model/economy; explanation for profits • “Shape” of costs irrelevant when discontinuities apply • innovator has lower costs, better quality than rivals

  9. A “Schumpeterian” model of competition • Archetypal industry telecommunications, post… • Starts as monopolised industry • Deregulation allows new firms to enter • Conventional expectation: competition will • Drive price down & quality up • Result in original monopolist losing market share • Result in many firms in industry • Actual results • Price often driven down • Quality generally up (but sometimes reliability problems: e.g., electricity in California, Queensland…) • BUT frequently also • Original monopolist remains dominant (Telstra) • Many entrants fail, industry remains concentrated

  10. A “Schumpeterian” model of competition • Regulators often claim negative outcomes mean ex-monopoly “abusing market power” • Telstra v Optus, Qantas v Virgin… • Ex-monopolies often claim outcome evidence that industry competitive • “We can’t help it if we’re better than the new guys…” • What is the truth? • “Anti-competitive behavior”?; or • “That’s just how the market works”? • Ormerod’s approach: model functionally competitive industry: Rapid innovation in costs & quality • Is there a correlation between outcome (low price & high quality) and structural picture of competition (lots of small firms)?

  11. A “Schumpeterian” model of competition • Approach is “multi-agent modelling” • Define “artificial agents” • “Consumers” who seek best price/quality combination • “Producers” who seek most effective price/quality combination for gaining market share • Run simulation and see what happens • Model • 1000 consumers • Each has different linear preferences for price v quality • Monopolist has 100% of market (1000 customers) at start • “By definition, a monopolist has a sales network which connects it to all consumers in the particular market.”

  12. A “Schumpeterian” model of competition • New entrants come in & offers are known by (randomly decided) fraction of consumers • “Consumers can only buy from those companies of whose product they are aware. The phrase 'sales network' in this paper means the set of connections from a firm to consumers.” • “consumers on the network of firm fi are both aware of the offer from firm fi and are willing to consider buying from it.” • First new firm might have sales network of (e.g.) 34% of market (340 customers) • Sales network held constant during simulation

  13. A “Schumpeterian” model of competition • “There are three obvious reasons why new firms in the market do not have potential access (in general) to all consumers, which can obtain either singly or in combination. First, the regulator could impose restrictions so that, for example and purely by way of illustration from the telephone market, a new entrant could be permitted to offer international calls but not domestic ones. Second, the marketing strategy of the firm may be such that not all consumers are aware that the firm is making an offer in the market. In reality, marketing strategies vary widely in effectiveness, and this is reflected in our model. Third, the firm itself may deliberately target only a small percentage of consumers. In the context of British land line phone calls, for example, several firms now specialise in offering cheap calls to India, say, or to the United States.” (8)

  14. A “Schumpeterian” model of competition • Initial (monopolist) price highest (1) and quality lowest (also 1 for convenience) • New entrants offer different (randomly allocated) price/quality combination between best (0,0) & (1,1) • Consumers can switch if new entrant’s deal more appealing to them than current deal • Switch probable only: each consumer has (randomly allocated) propensity to switch • Models real-world uncertainties • Costs in switching (ignored in conventional theory) • Uncertainty re reliability of new supplier • Heterogeneity of product means “new deal” might not be relevant to one consumer • Inertia: too many other things to do…

  15. A “Schumpeterian” model of competition • “product offers … are not perfect substitutes… the lowest (p,q) supplier may specialise in an offer which is not very important to a given consumer. Someone who makes only local phone calls will not be interested in a firm which provides only cheap international calls. Second, … consumers may have doubts about the reliability of a previously unknown supplier. … there may be costs involved in switching. To take an obvious example, if changing suppliers involved having to change telephone number – staying with the telecomm example - for most people the savings on price would have to be considerable to offset the inconvenience involved … consumers may simply exhibit inertia and stay with their existing supplier, perhaps because the savings involved are small.” (9)

  16. A “Schumpeterian” model of competition • 40 iterations (like 40 quarters = 10 years) • Possibility of new entrant(s) every quarter • At each iteration, each firm can alter price/quality offering to try to improve attractiveness to market • Firms desire to move to most popular (on average) price/quality combination • Probability, not certainty of switch: • “The ability of the firm to do achieve the desired (p,q) depends on the firm’s flexibility level ji.” (10) • Models variations in internal flexibility, etc.

  17. A “Schumpeterian” model of competition • After new price/quality offers made, consumers can decide to switch again: • “Consumers then review their choice of suppliers given the revised set of (p,q) from existing suppliers, and given the (p,q) offered by new entrants (if any) in that period.” (10) • Process causes “jiggling” of price/quality offers & market shares over time • Average price & quality tend to rise • What happens to structure of industry? • Is price lower, quality higher when market shares small? • Simulation run 1,000 times to see overall tendencies

  18. A “Schumpeterian” model of competition • Price outcome: • Not one single “market” price • Each firm offers different price • Average price tends towards competitive (0) outcome: • “The single most frequently observed outcomes for the market price is in the range 0.05-0.10. In other words, price does fall to a level close to the minimum which is feasible.” • However occasionally price is high…

  19. A “Schumpeterian” model of competition • “The mean level of market price after 40 periods is 0.145, with a minimum of 0.00007 and a maximum of 0.650. The inter-quartile range [from 25%-75% of outcomes] is between 0.057 and 0.206.” (17) • Quality behaves similarly: quality rises (tends towards 0) • So outcomes “competitive”; what about structure? • Not “competitive”, according to conventional theory • Monopolist hangs on to substantial share of market • “Quite frequently, the incumbent monopolist retains a very high market share… The average market share of the monopolist after 40 periods is 53.5 per cent, with a minimum of 3.4 and a maximum of 100 per cent. The inter-quartile range is wide, between 32.1 and 75.9 per cent.” (18)

  20. A “Schumpeterian” model of competition • Important factor in eventual market share is “flexibility” of monopolist—ability to match best price/quality offer of new entrants

  21. A “Schumpeterian” model of competition • “A high level of flexibility is by no means a guarantee of a high eventual market share, but the simple correlation between the two variables is 0.712.” (19)

  22. A “Schumpeterian” model of competition • Many new entrants “fail” in that market share becomes zero • “Grim” outcome in terms of standard theory but very similar to reality: • “The mean number of firms is 8.2, so that on average almost 12 out of the 20 firms fail completely i.e. have no sales at all. This seems compatible with the outcomes which are observed in practice (see, for example, Carroll and Hannan (2000)).” (20)

  23. A “Schumpeterian” model of competition • Market share outcome “uncompetitive” on standard theory: • But results fit data: • “a good approximation to the size distribution of the largest 8 firms after 40 periods is provided by a power law. [explained later] Axtel (2001) shows that this a general characteristic of the distribution of firm sizes in the United States.” (21) • “A log-log least squares fit of average market share in Figure 6 on the rank of the firm by market share … gives an R2 of 0.983 and an estimated exponent of –2.09” (21)

  24. A “Schumpeterian” model of competition • Would standard “competition policy” • Reduce share of ex-monopoly/largest firm • improve outcomes? • “it is often thought that reducing the market share of a monopolist (for example by competition policy) will ensure lower prices.” (23) • Regression shows almost no relationship between monopolist share of market and market price: • “We can examine whether there is any connection here between the eventual market share of the monopolist and the prevailing market price… The simple correlation between the two is –0.014.” (23-24)

  25. Aside: what’s happening to electricity price? • Competition policy forces “marginal cost” style bidding on suppliers. Price pattern over time is: Suppliers make 30% of revenue in 0.2% of year: ½ a day!

  26. A “Schumpeterian” model of competition • Effectively no correlation between market share of monopolist & market price: • What about market price & number of firms? • “standard economic theory implies a relationship between the equilibrium market price and the number of firms in the market. The fewer the number of firms, the more the price will be above the level which just covers both costs and a normal rate of profit.” (24)

  27. A “Schumpeterian” model of competition • “Figure 8 below plots the relationship between the eventual market price and the number of firms in the market. It is clear that there is little or no connection between the two. The simple correlation is in fact 0.05.” • “a very low price can obtain with just one or two firms in the market. Equally, a relative high price may exist with 10 or even 15 firms in the market.” (26) • Compare this to Cournot oligopoly theory:

  28. A “Schumpeterian” model of competition • “The key difference between our model and that of, say, the Cournot model is that with the latter there is a deterministic relationship between the number of firms in the market and the market price which obtains. The more the number of firms, the closer the price becomes to the theoretical level of a perfectly competitive market. In our model, in any particular solution of it there is no necessary connection at all between price and the number of firms… This difference between the Cournot model and our own is much more important than any similarities.” (26) • However, despite this empirical difference, outcome of model “better than” conventional theory

  29. A “Schumpeterian” model of competition • “Purely by coincidence, given the average number of firms which survive in 1,000 solutions of the model, the average price across these solutions is very similar to that of the in the standard Cournot model. • On average, after 5 years there are 5.54 firms in total in the market in the simulations of our model, rising to 8.21 after 10 years. Two widely used illustrations of the Cournot model are with a linear and log-linear market demand function, respectively. With a linear demand function, the mark-up on cost is (1 +1/(N+1)), and with a log-linear one it is (1 + 1/(N-1)). These imply, respectively, a market price after 5 years which is 15 and 22 per cent above cost. After 10 years the figures are 11 and 14 per cent above cost.” (26-27)

  30. A “Schumpeterian” model of competition • Conclusions: • “the market price generally falls from the level set by the initial monopolist to close to the minimum which is both technologically feasible and consistent with a normal margin of profit… • the market price is on average very similar to that implied by the Cournot equilibrium given the average number of firms with non-zero sales • however, in any individual solution of the model, the market price which eventually obtains is not really influenced by the number of firms which remain in the market • the monopolist retains, in general, a substantial share of the market

  31. A “Schumpeterian” model of competition • judged on the conventional criterion of the distribution of market shares, at any point in time the market structure is, in general, anti-competitive. But as the outcome on market price shows, the model is highly competitive in any meaningful sense of the word.” • “the majority of new entrants fail, which seems to fit empirical evidence • the distribution of market share is approximated closely by a power law, which again conforms with empirical evidence.” (28-29)

  32. A “Schumpeterian” model of competition • Implications for competition policy: • The results of this approach to the issue should give regulators and policy makers pause for thought when considering contestable markets. For example, it is not the case that a competitive market (in the sense of having a competitive price), will necessarily have lots of firms, or will have driven down the original incumbent’s market share. Further, although market share is often used as an indicator – indeed as a primary indicator – of the presence of monopoly power which may lead to anti-competitive behaviour, these results show that this can be seriously misleading. Finally, the existence of an incumbent by itself does not necessarily tell us much about whether the price is low or high and whether the market is competitive or not.” (29)

  33. A “Schumpeterian” model of competition • Ormerod/multi-agent model very different to conventional economics • Rather than single equations with simplifying assumptions, computer program with many realistic assumptions • some unrealistic ones can be altered later (e.g., no change in firms’ networks over time) • Outcome comparable to actual statistics • Majority of markets in USA dominated by top 8 firms • Firm size follows “power law” • Wide range of firm sizes in most industries • Industries neither “monopoly” nor “oligopoly” nor “competitive”

  34. Power Laws: an empirical regularity • “Power law” • Characteristic of systems where components interact with each other • E.g., tectonic plates on earth’s crust • Movement by one plate causes movements in others • Slip along one perimeter increases likelihood of slip on another • Large release of energy reduces overall energy • So large quake followed by other large quakes; • Period of high seismic activity followed by period of low • Results in linear relationship between log of size of event and log of frequency • Earthquake data is classic “power law” example • But many others—e.g., word usage in a language

  35. Power Laws: an empirical regularity • “Log of number of earthquakes of size X is a times log of X” • “Log of number of species extinctions of size X is a times log of X” • “Log of number of meteor impacts of size X is a times log of X” • In case of market competition • “Log of number of firms of size X in an industry is a times log of X”… • Firstly, earthquake data example • Plot of log of magnitudes of earthquakes (log of 4 on Richter scale = 4) against log of frequency (log of -1 = 1 such quake every ten years)

  36. Power Laws: an empirical regularity • Example: Earthquakes in S.E. USA: 1000 10 Number/Year 1 0.1 = 10-1 Richter scale

  37. Power Law in USA firm size • Size distribution of US firms follows similar law: • Plot of log of employees against log of per cent of firms with that many employees is straight line: • OLS regression line through the data… has a slope of 2.059 [and] adjusted R2 = 0.992) (Axtell 2001: 1819)

  38. Power Law in USA firm size • Same relationship turns up when analysed in terms of log of revenue (so 106=$1 million) and log of percentage of firms with that much revenue (roughly 10-1 or 1/10 = 10%)

  39. Power Law in USA firm size • Axell comments that “The Zipf [Power Law] distribution is an unambiguous target that any empirically accurate theory of the firm must hit.” (1820) • Ormerod model generates power law with exponent -2.09 • Conventional economic models (monopoly, oligopoly, monopolistic competition) don’t fit power law • All firms of one size; no firms of any other size

  40. Ormerod model • Standard economic model a set of (unfortunately false!) assumptions • Rising marginal cost • Homogeneous product, undifferentiated consumers • Price competition only • And mathematical maximisation equations • (True formula) “Maximise profit by setting gap between marginal revenue & marginal cost equal to (n-1)/n times gap between price and marginal cost” • Multi-agent model a computer simulation: • Explaining the program:

  41. Ormerod model • (1) Creates arrays to store information about • Consumers • consumers(:,1) = rand(1000,1); % price/quality weighting • consumers(:,2) = rand(1000,1); % switch prob. • consumers(:,3) = 1; % firm purchasing from • Firms • suppliers(1,1)=1; % Monopolist market penetration • suppliers(1,2)=1; % Monopolist initial price • suppliers(1,3)=1; % Monopolist initial quality • suppliers(1,4)=mean(consumers(:,1))*suppliers(1,2) + (1-mean(consumers(:,1))) *suppliers(1,3); % Consumer rating of monopoly • suppliers(1,5)=rand(1,1); % Monopolist flexibility

  42. Ormerod model • Network between them (which customers buy from which firms) • consfirm(:,1) = ones(1000,1); % All consumers connected to monopolist • Then for 40 iterations • for k=2:40 % k=1 is when monopoly only firm • IF there are less than 20 firms already • if firms < 20 • THEN create new firm(s) (probabilistically) • newfirms = round(1/5 + rand(1,1)); • Allocate initial properties of each new entrant:

  43. Ormerod model • for createnew = 1:newfirms • suppliers(firms+createnew-1,1)=rand(1,1); % market penetration; and also • % Initial Price offered • % Initial quality offered • % Average consumer rating of initial offers • % Firm Flexibility • How many consumers on firm’s network • network_size = round(suppliers(firms+createnew-1,1) * 1000); • Each consumer then rates each firm according to own preferences for price & quality:

  44. Ormerod model • for i=1:1000 % for each consumer • Rate offerings of all firms • offers = ( consumers(i,1) * suppliers(:,2) + (1-consumers(i,1)) * suppliers(:,3) ) .* full(consfirm(i,:)'); • Work out best offer • [bestoffer,bestofferfirm] = min(offers(find(offers))); • “Toss a coin” based on individual propensity to switch • prob_change = sqrt(consumers(i,2)* rand(1,1)); • Switch if coin “comes up heads” • if prob_change > 0.5 • consumers(i,3)=bestofferfirm; • end

  45. Ormerod model • Next firms “work out best practice”: • [C,I] = min(suppliers(actual_suppliers,4)); • “Toss a coin” • for i=1:firms • dice = rand(1,1); • prob_change = suppliers(i,5) + dice; • If coin “comes up heads” • if prob_change > 1 • Copy offerings of “best practice” firm: • suppliers(i,2)=suppliers(I,2); • suppliers(i,3)=suppliers(I,3); • end

  46. Ormerod model • Process continues to next round and each stage graphed • Ormerod’s program repeats process 1,000 times and records outcomes of each run. • This program runs once (40 iterations) and shows market outcome at each time step (1 iteration = 3 months “real time”) • Similar qualitative outcomes to Ormerod program • Monopolist tends to hang on to lion’s share of market • But competitive outcome (falling price/rising quality) independent of number of firms • A few sample runs:

  47. Ormerod model • (1) A monopolist with “the lot”:

  48. Ormerod model • “Optus defeats Telstra”…

  49. Ormerod model • “Yay” Competition at last…”

  50. Ormerod model • Wide range of structural outcomes • Little difference in practical outcomes • Price still falls • Quality still rises • The bottom line… Competition is a process, not a structure • Next week: • Macroeconomics from a management perspective • Managing a firm in a cyclical economy… • Aside: dynamic version of last week’s model

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