CHAPTER 9 : RELATIONSHIPS BETWEEN INDUSTRIES: The Forces Moving Us Toward Long-Run Equilibrium

 A competitive firm can earn a positive or negative profit in the short run until entry or exit occurs. In the long
run, competitive firms are condemned to earn only an average rate of return.
 Profit exhibits what is called mean reversion, or “regression toward the mean”.
 If an asset is mobile, then in equilibrium the asset will be indifferent about where it is used (i.e., it will make the
same profit no matter where it goes). This implies that unattractive jobs will pay compensating wage
differentials, and risky investments will pay compensating risk differentials (or a risk premium).
 The difference between stock returns and bond yields includes a compensating risk premium. When risk
premium becomes too small, some investors view this as a time to get out of risky assets because the market may
be ignoring risk in pursuit of higher returns.
 Monopoly firms can earn positive profit for a longer period of time than competitive firms, but entry and
imitation eventually erode their profit as well.
 Good to Great
 In 2001, Jim Collin published Good to Great, a book detailing how 11 companies used management prinicipals
to go from “good” to “great”
o By 2009 many of these same companies were bankrupt they had done amazingly well during the research
period but failed to outperform the market after the book’s publication. Why?
 Mr. Collin’s made two fatal errors
o The “fundamental error of attribution”
 Successful firms aren’t necessarily successful because of their observed behavior (this will be
discussing in a later chapter)
o Ignoring long run forces that erode profit
 Competition erodes above-average profit (this will be discussed in this chapter)
 COMPETITIVE FIRMS
 Definition: A competitive firm is one that cannot affect price.
o They produce a product or service with very close substitutes so they have very elastic demand
o They have many rivals and no cost advantage over them.
o The industry has no barriers to entry or exit
 Competitive firms
o cannot affect price: they can choose only how much to produce
o can sell all they want at the competitive price, so the marginal revenue of another unit is equal to the
price (sometimes called “price taking” behavior).
 For competitive firms price = marginal revenue
o So if P > MC , produce more and if P < MC , produce less.
 Perfect competition is a theoretical benchmark
o No industry is perfectly competitive, but many industries come close to it.
o The benchmark is valuable to expose the forces that move prices and firm profit in the long run.
 A competitive firm can earn positive or negative profit, but only in the short-run. IN the long run:
o Positive profit (P > AC) leads tp entry, decreasing price and profit
o Negative profit (P < AC) leads to exit, increasing price and profit
 In the long run, competitive firms are condemned to earn only an average rate of return.
 Competitive Firms in the Long Run
 Proposition: In equilibrium, capital is indifferent between entering one industry or any other, because P = AC
(economic profit is zero)
o In the short run, a price increase that leads to a profit increase attracts capital to existing firms or new
entrants come into the industry.
o This increases supply, which leads to a decrease in price until firms are no longer earning above-
average profit, so capital flow stops – long run equilibrium
 A competitive firm can earn positive or negative profit in the short run but only entry and exit occurs. In the long
run, competitive firms earn only an average rate of return.
 “Mean Reversion” of Profits
 Asset flows (entry and exit) force price to average cost
o e.g. even with demand and supply shocks that result in short-run price increases/decreases, economic
profit will always revert back to zero
o we say that “profits exhibit mean reversion”
 Silver lining to dark cloud (low profit will increase as firms exit the industry)
 Reversion speed is 38% per year
o So, if profits are 20% above the mean one year, in the next year they will be only 12.4% above the mean,
on average
 An analysis of over 700 business units found the 90% of both above-average and below-average profitability
differentials disappeared over a 10-year period
 Return on investment reverted back to the mean level of approximately 20% for both over-and under performers
(shown below)
 Indifference Principle
 The ability of assets to move from lower- to higher- valued uses is the force that moves an industry toward long-
run equilibrium
 Indifference principle: If an asset is mobile, then in long-run equilibrium, the asset will be indifferent about
where it is used; that is, it will make the same profit no matter where it goes
 Labor and capital are generally highly mobile assets
o They flow into an industry when profits are high and out of an industry when profits are negative
 Title?
 In 1924, Kleenex tissue was invented as a mean to remove cold cream.
 After studying customer usage habits, however, the manufacturer (Kimberly-Clark) realized that many customers
were using the product as a disposable handkerchief. The company switched its advertising focus, and sales more
than doubled.
 Kimberly-Clark built a leadership position by creating an innovative use for a relatively common product.
 As others saw the profits, however, they moved into the market.
 The managers of the company maintained profitability through a continuing stream of innovations and
investments in advertising/promotion.
o Printed tissue in the 1930’s
o Eyeglass tissue in the 1940’s
o Space-saving packaging in the 1960’s
o Lotion-filled tissue in the 1980’s
 Without this continuing stream of innovations and brand support, the product’s profit would have been slowly
eroded away by the forces of competition