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The Market and Industry, Lecture notes of Engineering

University of Warwick (Warw)Engineering

These comprehensive lecture notes cover essential topics in Market & Industry Analysis, including economics fundamentals, competition models, supply-demand dynamics, efficiency metrics, and market structures (monopoly, oligopoly, monopolistic competition). The notes also delve into advanced concepts like the SCP framework, HHI index, and UK competition policy, making them ideal for students studying business management, economics, or related fields. Clear definitions, diagrams, and real-world applications are included to aid understanding.

Typology: Lecture notes

2023/2024

Available from 04/03/2025

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Sam$Adams$ES187&'&Introduction&to&Engineering&Business&Management$
!
1!
02#$#Market#&#Industry#
1. Economics##
Strategic)managers!look!outwards!to!scan!the!environment!for!potential!environments.!
Economists!look!inwards!to!create!profit!maximisation.!
• Key!concepts!
– Scarcity!:>!leading!to!choice!and!opportunity!cost!
• Scarcity!is!different!to!poverty,!however!rich!you!are,!something!will!
be!in!scarce!supply.!
• With!scarcity!we!have!to!choose!from!the!available!alternatives.!
– Marginal,analysis,
• Evaluating!the!marginal!or!incremental!benefits!and!costs!associated!
with!manufacturing!one!more!unit!or!product.!!
• This!is!often!a!choice!between!manufacturing!two!alternative!
products!assuming!that!we!are!already!using!all!capacity!and!
therefore!to!make!product.!
– Substitution,and,incentives,
• Every!activity!has!a!substitute!and!so!if!the!opportunity!cost!of!an!
activity!declines!it!will!be!easier!to!consider!substitute!activities.!
• !An!incentive!can!be!in!the!form!of!higher!fuel!and!road!tax,!or!an!
inducement!could!be!offered!such!as!cheaper!public!transport.!!
• Assumptions:!!
– Rational!behaviour,!most!good!for!least!cost!
– An!individual!firm!has!no!influence!over!the!market!
!
MARKET,&,INDUSTRY,
• A!Market!is!made!up!of!a!group!of!products!considered!by!buyers!to!be!close!
substitutes.!
• An!Industry!encompasses!products!that!are!close!substitutes!from!the!supplier’s)
viewpoint,!in!terms!of!inputs,!employee!skills!and!production!processes.!
New!entry!to!a!market!is!most!likely!to!come!from!established!firms!closely!related!on!the!
production!side!but!not!necessarily.!
!
When!considering!prices!and!output!levels!the!market!is!the!more!relevant!concept.!
• Markets!are!distinct!from!one!another!when!the!change!in!price!or!specification!in!
one!product!has!no!impact!on!the!demand!for!firms!in!another!market.!!
• If!the!opposite!is!said!to!be!true!then!the!change!in!price!or!specification!has!a!large!
impact!then!the!products!are!said!to!be!homogeneous.!
!
Markets!can!also!be!separated!by!geography!but!international!trade!and!improved!
information!&!distribution!is!reducing!the!importance!of!geography.!
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02 -­‐ Market & Industry

1. Economics

Strategic managers look outwards to scan the environment for potential environments. Economists look inwards to create profit maximisation.

  • Key concepts
    • Scarcity -­‐> leading to choice and opportunity cost
      • Scarcity is different to poverty, however rich you are, something will be in scarce supply.
      • With scarcity we have to choose from the available alternatives.
    • Marginal analysis
      • Evaluating the marginal or incremental benefits and costs associated with manufacturing one more unit or product.
      • This is often a choice between manufacturing two alternative products assuming that we are already using all capacity and therefore to make product.
    • Substitution and incentives
      • Every activity has a substitute and so if the opportunity cost of an activity declines it will be easier to consider substitute activities.
      • An incentive can be in the form of higher fuel and road tax, or an inducement could be offered such as cheaper public transport.
  • Assumptions:
    • Rational behaviour, most good for least cost
    • An individual firm has no influence over the market MARKET & INDUSTRY
  • A Market is made up of a group of products considered by buyers to be close substitutes.
  • An Industry encompasses products that are close substitutes from the supplier’s viewpoint, in terms of inputs, employee skills and production processes. New entry to a market is most likely to come from established firms closely related on the production side but not necessarily. When considering prices and output levels the market is the more relevant concept.
  • Markets are distinct from one another when the change in price or specification in one product has no impact on the demand for firms in another market.
  • If the opposite is said to be true then the change in price or specification has a large impact then the products are said to be homogeneous. Markets can also be separated by geography but international trade and improved information & distribution is reducing the importance of geography.

2. Competition

PERFECT COMPETITION (ASSUMPTIONS)
  • A large number of small firms and consumers
  • No firm has any market power and no consumer can influence price
  • All firms produce exactly the same product
  • Firms are owned and managed by individual entrepreneurs
  • Decision makers are unboundedly rational and perfectly informed
  • Owners seek to maximise profits
  • Consumers seek to maximise utility TYPES OF COMPETITION In general as we move towards a Monopoly: The ability to make supernormal profits increases > prices faced by consumers increase

less incentive for cost efficiencies/innovation > economic efficiency declines Oligopoly – The market is dominated by a small number of sellers. Monopolistically Competitive markets have the following characteristics:

  • There are many producers and many consumers in a given market.
  • Consumers perceive that there are non-­‐price differences among the competitors' products.
  • There are few barriers to entry and exit.
  • Producers have a degree of control over price Therefore, in theory monopoly is bad for the economy. Privatisation of state owned business with monopolies is assumed economically inefficient. Monopolistic Competition

Perfect

Competition

Imperfect

Competition

Monopoly

Oligopoly

  • Total Costs initially increase at a higher rate (due to e.g. start up costs) but then ease off (Economies of Scale)
  • Beyond a certain volume, the costs start to increase at a higher rate again (e.g. exceed production capacities)
  • To maximise profits we want the largest gap between the total revenue and total cost curves. Profit (π) = Total Revenue (TR) − Total Costs (TC) 𝜋!"#: Marginal Revenue (MR) = Marginal Cost (MC)
  • As market price is constant for each unit sold, the Demand (D) is horizontal. o Average Revenue is equal to Marginal Revenue (MR).
  • If new suppliers enter the market, this causes a shift in the market supply curve from S 1 to S 2.
  • In the long term, equilibrium will be established. Profit Maximisation (Graphically): Q 1 Break Even Total Fixed Cost Q 2 Max. Profit Slope = Marginal Revenue MR Slope = Marginal Cost MC Q 3 Max. Revenue £ Total Revenue, TR Q Profit π Total Costs, TC Equilibrium position of the firm in perfect competition: AR Average Revenue MR Marginal Revenue AC Average Costs MC Marginal Costs Long Run for the Firm S 2 PL D S 1 PM Long Run for the Industry QM QL Normal profit Price PL D = AR = MR QL Market or long-term price MC^ AC

Equilibrium position of the firm

in perfect competition: AR Average Revenue

MR Marginal Revenue AC Average Costs MC Marginal Costs Short Run for the Monopoly Price PM^ D = AR = MR AC Super or abnormal profit MC QM S 2 PL D S 1 PM Long Run for the Industry QM QL

4. Economic Efficiency

Dynamic Efficiency -­‐ The ability to adapt quickly and at low cost to change (thereby maintaining output and productivity performance despite economic shocks. Static Efficiency -­‐ Exists at a point in time and focuses on how much output can be produced now from a given stock of resources, and whether producers are charging a price to consumers that fairly reflects the cost of the factors of production used to produce a good or a service. There are two main types of static efficiency:

  • Allocative Efficiency is achieved when the value consumers place on a good or service equals the cost of the resources used up in production. o Condition required is that price = marginal cost o Total economic welfare is maximised.
  • Productive Efficiency refers to a firm's costs of production and can be applied both to the short and long term. o Achieved when the output is produced at minimum average total cost (AC). o When this happens the firm is exploiting most of the available economies of scale. o Productive efficiency exists when producers minimise the wastage of resources in their production processes. o It can comprise: § Factor-­‐Price Efficiency -­‐ The price charged for the item efficiently represents the cost of producing it. § Technical Efficiency -­‐ Producing as much as possible with a given level of inputs. Concepts of Economic Efficiency Economic Efficiency Dynamic Efficiency Static Efficiency Allocative Efficiency Productive Efficiency Factor-Price Efficiency Technical Efficiency

Price Elasticity of Demand (PED) = % Change in Quantity Demanded % Change in Price Inelastic < 1 < Elastic PED > 1 : Price Elastic

  • Demand is responsive to a change in price. PED = 1 : Unit Elasticity
  • Demand changes proportionately to a price change. PED < 1 : Price Inelastic
  • Demand is not very responsive to changes in price Factors:
  • Number of close substitutes within the market
  • The more (and closer) substitutes available in the market the more elastic
  • The substitution effect will be quite strong.
  • Luxuries versus necessities
  • Necessities tend to have a more inelastic demand curve, whereas luxury goods and services tend to be more elastic.
  • Percentage of income spent on a good
  • It may be the case that the smaller the proportion of income spent taken up with purchasing the good or service the more inelastic demand
  • Habit-­‐forming goods
  • Goods such as cigarettes and drugs tend to be Inelastic in demand.
  • Preferences are such that habitual consumers of certain products become de-­‐sensitised to price changes.
  • Time under consideration
  • Demand tends to be more elastic in the long run rather than in the short run.

6. Sales Revenue

Total Revenue (TR) = Price (P) × Quantity (Q) ELASTIC DEMAND INELASTIC DEMAND OTHER ELASTICITIES Income Elasticity of Demand -­‐ The responsiveness to a change in consumer incomes % Change in Quantity Demanded % Change in Income Cross-­‐Price Elasticity of Demand -­‐ The responsiveness of demand for one good to change in the price of another. % Change in Demand for One Good % Change in Price of the Other

  • NOTE: The Price Elasticity of Supply can be calculated by replacing the numerator.

Sales Revenue

Total Revenue (TR) = P x Q

P (£) D 3000^ Q 2 1000 2000 4000 1 3 Total Revenue Elastic Demand 4 5 D P (£) (^10 20) Q If P rises, Q falls proportionately more so TR falls or If P falls, Q rises proportionately more so TR rises. (TR changes in same direction as Quantity, Q) ∴ To increase TR, lower price Inelastic Demand 4 8 D P (£) (^15 20) Q If P rises, Q falls proportionately less so TR rises or If P falls, Q rises proportionately less so TR falls. (TR changes in same direction as Price, P) ∴ To increase TR, raise price

KEY FEATURES OF OLIGOPOLY
  • A few firms selling similar product
  • Each firm produces branded products
  • Likely to be significant entry barriers into the market in the long term which allows firms to make supernormal profits.
  • Interdependence between competing firms (Businesses have to take into account likely reactions of rivals to any change in price and output) THEORIES ABOUT OLIGOPOLY PRICING There are four major theories about oligopoly pricing:
  • Firms collaborate to charge the monopoly price and get monopoly profits
  • Firms compete on price so that price and profits will be the same as a competitive industry
  • Prices and profits will be between the monopoly and competitive ends of the scale
  • Prices and profits are "indeterminate" because of the difficulties in modelling interdependent price and output decisions PRICE LEADERSHIP IN OLIGOPOLISTIC MARKETS When one firm has a dominant position in the market the oligopoly may experience price leadership. The firms with lower market shares may simply follow the pricing changes prompted by the dominant firms. We see examples of this with the major mortgage lenders and petrol retailers.

9. Economists View of Profitability

• PROFITABILITY
  • Long run return on capital employed (‘return on total assets’ ratio)
  • LEVELS OF PROFITABILITY
  • Normal profits -­‐ minimum return necessary to attract and maintain capital in this industry
  • Sub-­‐normal profits encourage firms to leave this industry, reducing the capital invested
  • Super-­‐normal or ab-­‐normal profits -­‐ rate of return in excess of the normal return that will attract new capital into this industry
  • Economists measure profitability by profits before interest and tax divided by the total assets. By including the risk free and risk premium there is an inclusion for the opportunity costs.
  • Taxation is also ignored as it is assumed taxation affects all firms equally.
  • If there are abnormal or super profits then something must be affecting competition.
PRICE LEADERSHIP IN OLIGOPOLISTIC MARKETS
  • When one firm has a dominant position in the market the oligopoly may experience price leadership.
  • The firms with lower market shares may simply follow the pricing changes prompted by the dominant firms.
  • Niche strategies – avoid head on competition, common in case studies for the exams. KINKED DEMAND CURVE
  • When a company estimates the effect of changing prices within an oligopoly, this results in a kinked demand curve, with different outcomes.
  • It is in many ways best to stay at the same price! COLLUSION “Collusion is an explicit or implicit agreement between existing firms to avoid competition” Outcomes:
  • Both agree to raise prices and both increase total profits
  • One lies! Pretend to agree to raise prices, let their rivals increase price but keep your price the same and increase your market share & total profits.
  • Both lie! Pretend to agree to raise prices. This could start a price war, resulting in both firms suffering reduced profits. Collusion is illegal in the UK unless it can be argued as being in the public interest. ‘ Co-­‐operation ’ to share development costs on new products, improve the supply chain etc. is common. Price fixing – Competitors get together to agree the price, assume higher than normal profits, but maybe not too high so as to attract attention of regulator, office of fair trading, competition commission. Q 0 P 0 Quantity £ D Given this percept firm sees that reve fall whether price i or decreased, so the best strateg price at P 0. Price will tend to b even in the face o in marginal cost. Oligopoly characteristics

The kinked demand curve (cont

COLLUSION
FORMAL

Cartel Price Fixing and ‘Limit pricing’ Limiting output (all normally considered illegal) TACIT Price leadership Target different market niches, geographic regions Oligopoly characteristics

Collusive oligopoly (or co-operation)

Oligopoly characteristics

Non collusive oligopoly

(or non-co-operation)

NON COLLUSIVE
RIVALRY

PRICE Rigid prices Price war NON PRICE Product differentiation High advertising & branding Heavy promotions

11. Structure-­‐Conduct-­‐Performance (SCP)

Approach

  • An alternative to Porter’s 5 forces to characterise and analyse markets & industries
  • Assumes:
    • Firms maximise profits
    • Consumers maximise utility
      • Demand theory tells us that consumers divide their disposable income between goods and services so as to maximise their satisfaction or utility.
      • They are rational, remember and have perfect information about all possible choices.
    • Markets tend to a position of equilibrium
      • We looked in perfect competition at how supernormal or abnormal profits attract in new entrants until profits fall to a normal level for that industry.
      • Equilibrium when existing firms stay in, no new firms enter.
    • Conditions & structure will determine conduct, which in turn determines performance Structure = a group of companies offering the same product or service Conduct = their price setting behaviour Performance = profitability Advantages of this approach
  • Easy to understand and apply
  • Not industry specific
  • Easily used for comparative purposes STRUCTURE
  • Nature of the product
  • Cost conditions
  • Economies of scale
  • Number of rivals, buyers and suppliers
  • Entry & exit barriers
  • Demand conditions o How strong the market is Generally believed that the more firms that enter a market then the lower prices will be for the consumer.
MEASURING

To assess the level of competition we need to determine how concentrated a market or industry is

  • A monopoly has the most concentrated structure
  • Oligopolies are described as having a highly concentrated structure
  • Monopolistic competition would be described as having a structure with very low concentration CONCENTRATION RATIO In economics, the concentration ratio of an industry is used as an indicator of the relative size of firms in relation to the industry as a whole. This may also assist in determining the market form of the industry.
  • Measures the % of a market or industry accounted for by the n largest firms by output
  • Is an indicator of the market power of these n firms
  • The highest concentration is a monopoly (C1 of 100%)
  • To describe a market or industry you normally measure the top 3 or top 5 firms
  • C3 of 70% means 3 firms account for 70% of sales
  • C5 of 80% means 5 firms account for 80% of sales
  • Office of National Statistics in the UK calculates C5 ratios Output can be measured in many different ways. Most common measures are:
  • Employee numbers
  • Sales revenue (also known as income or turnover)
  • Gross value added Advantages
  • Simple to calculate
  • Easy to understand
  • Readily available for UK industries groups Disadvantages
  • Choice of n (number of firms) is arbitrary and may be inappropriate
  • It tells us nothing about the total number of firms
  • It tells us nothing about the market shares of the biggest n firms
  • Firms operating in several industry groups are hard to classify

Advantages

  • It includes all firms in the industry;
  • As the market shares are squared, it gives importance to larger firms Disadvantages
  • Data on market shares for all firms is not so easy to find
  • It is more difficult to calculate and to understand than concentration ratio
  • Firms operating in several industry groups are hard to classify
  • Geographical monopolies can be hard to spot Principles of UK Competition Policy (Enterprise Act 2002)
  • Highly concentrated market structures, containing scale or complex monopolies, are likely to behave more like a monopoly. Drawbacks of concentrated structures may be offset by: o Contestability or the threat of contestability o Innovation that benefits society
  • Competition law is applied to a wide range of markets.
  • Competition has direct benefits for consumers and indirect benefits on upstream and downstream markets.
  • Case-­‐by-­‐case studies are necessary to quantify net economic benefits and costs of monopoly. CONTESTABLE MARKET
  • No barriers to entry
  • No barriers to exit
  • One firm has a monopoly or there are only a small number of incumbent firms
  • Threat of new entrants ensures the monopoly firm remains competitive and keeps profits at a normal level CONDUCT
  • Pricing policies
  • Marketing & advertising
  • Financing policies
  • Degree of competition or collusion
  • Output decisions
  • Level of R&D, innovation
  • Merger behaviour
PERFORMANCE
  • Profitability
  • Productive efficiency
  • Size & growth of industry output
  • Development of products & technology The mean profit level for the industry tells you how attractive the industry is, normal means you stay in, sub-­‐normal means you get out, super-­‐normal encourages new entrants.
  • A wide spread may mean that
  • Several different strategies are being adopted, differentiation with higher profits, low cost with lower profits, or
  • There is a big difference in profits between the worst and best performing firms.
  • A narrow spread may mean that
  • Only firms adopting a certain strategy and performing at a similar level have survived, or
  • There is a cartel or tacit collusion amongst the firms.
  • A big change in average mean profits may mean that
  • There is a economic recession or boom, or
  • There has been a significant change in input costs, technology, output prices etc. Average π 1 No. of firms With this π Four aspects to consider:
  1. Changes and rates of change Averageπ 2 π (profitability) SCP approach Profitability performance in an industry Average π for an industry No. of firms With this π Four aspects to consider:
  2. Mean for an industry π (profitability)
  3. Spread
  4. Shape of the curve SCP approach Profitability performance in an industry