Industrial Organization: Competitive Markets

Prof. John M. Abowd

Themes of Today's Lecture

There's no such thing as fixed costs
Long run cost conditions (choice of technology)
Long run supply
Returns to scale
External economies and diseconomies of scale
Changing technologies

Competitive Markets

Every demander is a price-taker (no buyer can influence the price).
Every supplier is a price-taker (no seller can influence the price).
The market price is known to all potential buyers and sellers and anyone who wishes to trade at that price can do so.

Who are the Supplier's Competitors?

Are there other firms with similar cost structures?
If so, then any one of them can enter the market and sell at the same prices as existing competitors
If not, then the competitor with the cost advantage will dominate the market.

What is the Market?

The market is the area that a firm can serve with its cost curves intact.
Every potential customer within that market (the entire market demand) represents a potential sale for every firm that sells, or could sell, the product.
Many competitors survive only if they have similar cost structures and, thus, cannot individually dominate the market.

Can the Technology Be Reproduced?

If any one firm's technology can be fully reproduced, then it has many competitors even if they are not in the market.
System-fixer cannot dominate its market unless its cost curves are lower than all its potential competitors.

There's No Such Thing as Fixed Costs

Because firms can change the scale of their operations by reproducing their current cost curves, there really is no such thing as a fixed cost.
Whether to expand, continue as-is, or contract, depends upon why the price is above, at, or below minimum average cost.
Firms must use the technology that has the lowest average total cost in order to survive in the market.
Fixed costs are, therefore, a short run phenomenon.
By choosing the correct scale of operation the firm sets its "fixed costs" appropriately.

3 Potential Technologies

Long Run Cost Curves
Firm A (Capital investment A)				Firm B (Capital Investment B)				Firm C (Capital Investment C)
Q	Total Costs	Firm A Average Total Cost	Marginal Cost (midpoint formula)	Q	Total Costs	Firm B Average Total Cost	Marginal Cost (midpoint formula)	Q	Total Costs	Firm C Average Total Cost	Marginal Cost (midpoint formula)
0	80			0	160			0	240
1	100	100.00	15.00	1	161	161.00	1.50	1	250	250.00	7.50
2	110	55.00	10.50	2	163	81.50	2.50	2	255	127.50	6.00
3	121	40.33	13.50	3	166	55.33	3.00	3	262	87.33	6.50
4	137	34.25	22.00	4	169	42.25	4.00	4	268	67.00	6.00
5	165	33.00	33.00	5	174	34.80	5.50	5	274	54.80	6.00
6	203	33.83	46.50	6	180	30.00	7.00	6	280	46.67	6.50
7	258	36.86	65.00	7	188	26.86	14.00	7	287	41.00	7.50
8	333	41.63	90.00	8	208	26.00	26.00	8	295	36.88	8.50
9	438	48.67	122.50	9	240	26.67	50.00	9	304	33.78	10.00
10	578	57.80		10	308	30.80	84.00	10	315	31.50	13.00
11				11	408	37.09	125.00	11	330	30.00	30.00
12				12	558	46.50		12	375	31.25	52.50
13				13				13	435	33.46	80.00
14				14				14	535	38.21	140.00
15				15				15	715	47.67

There are really three different ways for system fixers to do business. (Table also included in handout.)
Firms A, B and C illustrate the possibilities.
Firm A looks just like System-fixer, firm B is uses twice the capital and firm C uses three times the capital.

Long Run Cost Curves

Firm A can only survive at prices above $33/installation.
Firm B can survive at prices above $26/installation.
Firm C can survive at prices above $30/installation.
Firm B’s capital investment is long run superior to that of firms A and C.
Firm B is operating at the minimum (and only) efficient scale.
Firms like B will dominate the competitive market.

From Cost Curves to Long Run Supply

Any firm's long run average total cost curve consists of the minimum of the three curves illustrated on the right.
For system-fixer firms, the long run average total cost curve is firm A's (blue) until 6 units, firm B's (red) from 6 to 9 units and firm C's (brown) from 10 units onward.
The industry (market) long run average total cost curve is just a replication of firm B's (red) average total cost curve.

Returns to Scale (Firm)

When we allow all inputs to vary, returns to scale measure what happens to average total costs as all inputs increase in proportion.
If increasing all inputs in proportion lowers average total costs, then the firm (or technology) displays increasing returns to scale.
If increasing all inputs in proportion leaves average total costs unchanged, then the firm (or technology) displays constant returns to scale.
If increasing all inputs in proportion raises average total costs, then the firm (or technology) displays decreasing returns to scale.
We can also define returns to scale in terms of what happens to total output when all inputs increase in proportion.
If increasing all inputs by 10% increases total output by MORE than 10%, then the firm (or technology) displays increasing returns to scale.
If increasing all inputs by 10% increases total output by EXACTLY 10%, then the firm (or technology) displays constant returns to scale.
If increasing all inputs by 10% increases total output by LESS than 10%, then the firm (or technology) displays decreasing returns to scale.

Returns to Scale in System-fixer Firms

Based on the three technology graph above.
For system-fixer firms, the long run average total cost curve is firm A’s (blue) until 5 units, firm B’s (red) from 6 to 10 units and firm C’s (brown) from 11 units onward.
Firms in the system-fixer market display increasing returns to scale up to about 7 units of output, constant returns to scale at 8 units and decreasing returns to scale beyond 8 units.

Long Run Supply in the Industry

Firms in the industry must replicate the minimum efficient scale to remain competitive.
Firm's that are "too small" or "too large" have minimum average total costs that are too large compared to the efficient scale.
As long as the minimum efficient scale is well below the size of the market, competitive conditions will result.

Long Run Supply in the System-fixer Market

The market demand for system installations is shown by the blue line in the graph.
The market is very much larger than firm’s at the efficient scale, so we expect competitive conditions to prevail.
The long run supply (in red) reflects the technological and competitive conditions in the market: surviving firms must operate at the scale of firm B at a minimum average total cost of $26/installation.
Short run supply is shown in brown.

Increases in Demand

When demand increases and is expected to remain at the increased level, the short run response is to move along the short run supply curve--higher price and greater quantity supplied.
The long run response is to have entry in the market, movement along the long run supply curve--price returns to the minimum average total cost and quantity supplied increases.

Increase in Demand in the System-fixer Market

Demand increases in the market as indicated by the new (black) demand curve.
The short run response is an increase in price with not much additional quantity supplied (point A), movement along the short run supply curve.
The long run response is a return to the original price of $26/installation and an expansion of quantity supplied along the long run supply curve (point B).

External Economies and Diseconomies of Scale

If the industry long run supply curve is perfectly elastic (horizontal), then the industry exhibits no external economies or diseconomies of scale. The industry grows by replicating firms at the efficient scale. This is called a constant cost industry.
If the industry long run supply curve is upward sloping, then the industry exhibits external diseconomies of scale. The minimum average total cost of all firms in the industry rises as the size of the market grows.
If the industry long run supply curve is downward sloping, then the industry exhibits external economies of scale. The minimum average total cost falls as the size of the industry grows.

Constant Cost Industry

When we draw the long run supply curve as a horizontal line, we are asserting that there are no external economies or diseconomies of scale.
We call this a constant cost industry.
Lack of economies or diseconomies of scale means that growth of the industry doesn't foster technological improvements and doesn't change the prices of inputs.

External Diseconomies of Scale

When an industry long run supply curve slopes upward, the industry exhibits external diseconomies of scale.
This can occur because the prices of the inputs rise as the industry expands.
This can also occur because the industry becomes "congested" and the minimum average total cost at the efficient scale rises.
As a competitive industry grows, its demand for certain specialized factors increases (information systems specialists in the accounting service industry, fabrication equipment in the microprocessor industry).
Increased demand for specialized factors means that the equilibrium price of these factors will increase (movement along a factor supply curve--increased quantity and increased price of the factor).
So as the industry (not the firm) grows the price of these specialized factors increases and the minimum average total cost rises.
Thus, the long run supply curve slopes upward.

External Economies of Scale

When the long run supply curve slopes downward, there are external economies of scale.
This can occur in competitive markets because technological improvements reduce the minimum average total cost at the efficient scale without allowing a single firm to dominate the market.
Often, however, external economies of scale mean that a single firm, or group of firms will come to dominate the market and the competitive assumptions will no longer hold.
As certain newly created competitive industries grow, the incentives to invest in research and development to produce new technologies increase. Such industries are sometimes called emerging industries. (Biotechnology in the 1980s, network information systems in the 1990s).
The result of the increased research and development investments is new kinds of capital (human and physical) that are specialized to the emerging industry (gene sequencers, client-server information systems).
This newly invented capital is licensed and sold to many firms, so the industry retains its competitive structure; however, the specialized capital is more efficient than the older capital.
Thus, all firms have lower minimum average total costs and the long run supply curve in the industry slopes down.

Long Run Supply in Telecommunications

When wire based technologies dominated the telecommunications industry, the long run supply curve for message services (telephone calls) was downward sloping.
One firm (AT&T) dominated the market and was regulated, as were the other firms supplying message services.

Change in Technology in the Telecommunications Industry

The advent of wireless technologies in telecommunications (microwave and satellite for long distance and cellular for local calls) has changed the cost conditions in the telecommunications industry.
The minimum efficient scale is now much smaller.
In the long distance market, there is already tremendous competition, because the industry is no longer served by a single supplier, we can apply our competitive analysis. Supply expands by the entry of firms using the efficient (wireless) technology.
The same thing is happening to local telecommunications although both wired and wireless technologies are possible at efficient scales.

Summary of Lecture

Long run supply conditions are determined by the efficient scale in the industry.
Long run supply is driven by entry and exit of firms more than by expansion and contraction of existing firms.
External diseconomies and economies of scale can cause the long run supply curve to slope upward (diseconomies) or downward (economies) even in competitive markets with entry and exit.
Changing technology can completely reshape the long run supply conditions in an industry.

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