Managerial Economics

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 gt 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
• Ormerods 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 cant help it if were better than the new
  guys
• What is the truth?
• Anti-competitive behavior? or
• Thats just how the market works?
• Ormerods 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 entrants 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 firms 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 monopolistability 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 whats 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/(N1)), 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 incumbents
  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 earths 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 otherse.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 1061 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) dont 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 k240 k1 is when monopoly only firm
• IF there are less than 20 firms already
• if firms lt 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 1newfirms
• suppliers(firmscreatenew-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 firms network
• network_size round(suppliers(firmscreatenew-1,1
  ) 1000)
• Each consumer then rates each firm according to
  own preferences for price quality

44
Ormerod model

• for i11000 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 gt 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 i1firms
• dice rand(1,1)
• prob_change suppliers(i,5) dice
• If coin comes up heads
• if prob_change gt 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
• Ormerods 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 lions 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 weeks model