GSBS6410

Economics of Competitive Advantage

Week 5
Market Structure
 OUTLINE
1. Readings and Introduction
2. Market Structure
3. Perfect Competition
4. Monopoly
5. Economies of Scale & Scope
6. Questions for Discussion

2
 GSBS6410
Readings for this lecture

• Froeb et al 2018, Managerial Economics, Chapter 9 and any

intermediate microeconomic textbook, especially one of the
following
1. Arnold, Roger A., (2016) Microeconomics, 12th Edition,
Cengage. Chapter 9 (if you think our text is too simple).
2. Layton A, Robinson T, and Tucker I. (2016) Economics
For Today, Fifth Asia Pacific Edition, Cengage Learning
Australia, Melbourne. Chapter 7 (if you think our text is
too hard).
Market Structure

4
 Perfect Competition
• A competitive firm can earn 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).

5
 Monopoly
• 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.
• The difference between stock returns and bond
yields includes a compensating risk premium. When
risk premium become 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.

6
 Good to Great
• In 2001, Jim Collin published Good to Great, a
book detailing how 11 companies used
management principals to go from “good” to
“great”
– 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?

7
 Good to Great
• Mr. Collin’s made two fatal errors
– The “fundamental error of attribution”
• Successful firms aren’t necessarily successful because
of their observed behavior (this will be discussed in a
later chapter)
– Ignoring long-run forces that erode profit
• Competition erodes above-average profit (this will be
discussed in this chapter)

8
 Competitive Firms

• Definition: A competitive firm is one that

cannot affect price (price taker).
– They produce a product or service with very close
substitutes so they have very elastic demand
– They have many rivals and no cost advantage over
them
– The industry has no barriers to entry or exit

9
 Competitive Firms
• Competitive firms
– cannot affect price; they can choose only how much to
produce
– 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
– so if P>MC, produce more and if P<MC, produce less

10
 Competitive Firms
• Perfect competition is a theoretical benchmark
– No industry is perfectly competitive, but many industries
come close to it
– 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:
– Positive profit (P>AC) leads to entry, decreasing price and
profit
– Negative profit (P<AC) leads to exit, increasing price and profit

11
Competitive Firms in the Long Run

• In the long-run, competitive firms are condemned

to earn only an average rate of return.

• 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.

12
 “Mean Reversion” of Profits

• Asset flows (entry and exit) force price to

average cost
– e.g. even with demand and supply shocks that
result in short-run price increases/decreases,
economic profit will always revert back to zero
– We say that “profits exhibit mean reversion” or
normal economic profit is zero for perfectly
competitive market

13
 “Mean Reversion” of Profits
• Reversion speed is 38% per year
– 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

14
 “Mean Reversion” of Profits

• Return on investment reverted back to the mean level of

approximately 20% for both over- and underperformers
(shown below)

15
 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
– They flow into an industry when profits are high
and out of an industry when profits are negative
16
 Indifference Principle Example
• Suppose Sydney is more attractive to live in
than Newcastle
• If labor is mobile, people will move from
Newcastle to Sydney
– This will increase demand for housing g housing
prices will increase to a point where Sydney
becomes as unattractive as Newcastle g migration
to Sydney will stop g long run equilibrium!

17
 Compensating Wage Differentials

• Wages adjust to restore equilibrium

– The indifference principle tells us that in long-
run equilibrium, all professions should be
equally attractive, provided labor is mobile
– Once long-run equilibrium is reached,
differences in wages are “compensating wage
differentials”

18
 Compensating Wage Differentials

• Compensating wage differentials reflect

differences in the inherent attractiveness of
various professions
– Example: embalmers make 30% more than
rehabilitation counselors because it is considered
a relatively unattractive profession

19
 Finance: Risk vs. Return
• Can apply long-run analysis to fundamental
relationships in finance
– Investors prefer higher returns and lower risk if two
investment options have the same return and one is less
risky, the less risky one will be chosen and it will bid up
the price of the less risky investment
– The higher price decreases the investment’s expected
rage of return
– Therefore, in equilibrium, differences in the rate of return
reflect differences in the riskiness of the investment, e.g.
risk premium
Expected return = (E[Pt+1] - Pt)/Pt 20
 Finance: Risk vs. Return
• The higher return on a risky stock is known as the
risk premium
• In equilibrium, differences in the rate of return
reflect differences in the riskiness of an investment.
• Risk premia are analogous to compensating wage
differentials: just as workers are compensated for
unpleasant work, so too are investors
compensated for bearing risk

21
 Stock Volatility and Returns
• CBOE Volatility Index (VIX) against the price of
the S&P 500 stock index (GSPC)
• From Fall of 2008 through the Spring of 2009,
the stock market declined by about 50% while
the volatility index increased by about 100%
• Greater volatility reduced stock prices,
increased expected returns to compensate
investors for bearing more risk

22
Change since Jan. 2008 (%)
Stock Volatility and Returns

23
 Historical Equity Risk Premium
• Government bonds are considered risk-free,
they returned 1.7% over the last 80 years while
stocks returned 6.9%.
• The difference is a risk premium that
compensates investors for holding the more
risky stocks
• The equity risk premium of stocks over bonds
(in the graph below) has varied over time, from
0% to 9%

24
Historical Equity Risk Premium

25
 Monopoly-Different Story, Same Ending

• Monopoly firms have attributes that protect

them from the forces of competition:
– They produce a product or service with no close
substitutes
– they have no rivals
– there are barriers to entry, so no other firms can
enter the industry.

26
 Monopoly-Different Story, Same Ending
• Proposition: In the very long run, monopoly
profits are driven to zero by the same
competitive forces though
– Entry makes demand more elastic (P-MC)/P=1/|e|,
which forces price back down towards MC
– Example: In Oct. 2001, Apple released the iPod, which
was a unique, user-friendly product with low elasticity
of demand and high margins. Rivals began producing
competing music players, which made demand for
iPods more elastic. This reduced price-cost margins
and lowered profit for Apple.
27
 Case Study of Firm Analysis
• In 1924, Kleenex tissue was invented as a means 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.

28
 Case Study of Firm Analysis
• 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 investment
in advertising/promotion.
– Printed tissue in the 1930’s
– Eyeglass tissue in the 1940’s
– Space-saving packaging in the 1960’s
– Lotion-filled tissue in the 1980’s.

29
 Case Study of Firm Analysis
• As others saw the profits, however, they moved into the
Without this continuing stream of innovations and brand
support, the product’s profits would have been slowly eroded
away by the forces of competition.

• (Please note that a group must be formed or assigned this

week. You are then encouraged to undertake some similar
case study like this to get the group research project done.
Please refer Page 5 of the course outline for details)

30
 Questions for Discussions

1. Suppose that new entry decreased your demand

elasticity from -2 to -3 to make your demand more
elastic, by how much should you adjust your price of
$10?

2. Describe the difference in economic profit between a

competitive firm and a monopolist in both the short run
and long run. What should take longer to reach the long-
run equilibrium?

31