Competition and Concentration

Concentration writ large

• There are hundreds of millions of business and companies in the world

• Yet the largest 1000 companies produce 80% of the worlds industrial output

• In the US, about 1200 companies produce more than 50% of the GDP.

The coexistence of competition and concentration

• The degree of economic concentration depends on the ability of firms to ward off competition

• Competition impinges on profit margins

• Competitive forces limit what a firm can do and shapes what it is driven to do

Businesses hate competitionbut it forces them to change

Three-fourths of 531 corporations surveyed identified economic pressures from competitors as one of the primary factors motivating their restructuring efforts.

Example of Cutting into Profits• BEIJING/HONG KONG (Reuters) - China Mobile (0941.HK), the

world's largest mobile carrier, faces a further squeeze on profit margins as competitive pressures intensify and an expensive buildout of a new, untested 3G network weighs. The firm, which had 493 million users at the end of June, on Thursday posted its slowest interim profit growth since it listed in 1997 and said it expects average revenue per user (ARPU), a key barometer of earnings, to slide in the months to come. Like smaller rivals China Unicom (0762.HK) and China Telecom (0728.HK), which now compete with a full range of services after a major Beijing-ordered restructuring last year, China Mobile is aggressively moving into poorer and less profitable rural areas as urban markets become saturated."We can't preserve such a (high) margin for the long term," Chief Financial Officer Xue Taohai told a media briefing.

Outline

1. Businesses must compete for profits, and they do so by manipulating the determinants of their own profit rates.

2. Business competition takes three principal forms: (a) price competition) (b) breakthroughs; and (c) achieving monopoly power.

3. For all three types of competition, firms must invest to compete.

4. Because firms must invest to compete, competition is inherently dynamic:

5. The competitive scramble produces different profit rates among firms; but, conversely, it also tends to equalize profit rates

6. The dynamics of competition produce both economic concentration (which results when large firms displace or acquire smaller firms) and decentralization

In order to survive competition, firms manipulate the determinants

of profit rate

r(Pzef ) (Pmm) w

Pc 1u c

Price Competition

• Firm has 10 machines. It makes profits of $1000 and each machine costs $1000 -->rate of profit =10%

• Now what is the profit rate per hour if it can use each of its 10 machines only to 50% capacity?

• Since each machine is only being used to 50%, the potential profit rate is being cut by half.

But.. there is a remedy..

r(Pzef ) (Pmm) w

Pc 1u c

There is a relationship between the Price of the output and the capacityUtilization.

We know from the law of demand that if the price is lowered, more output canbe sold

A ha..

• Firm can increase output and increase u by reducing Pz.

• But, the overall effect on profit rate is unclear: If the rise in demand is not very large, then u will not rise sufficiently to offset negative effect on r from reduction in Pz.

• This is linked to a notion that we have heard of: elasticity

Elasticity and Price Competition

• Will price competition be more or less when the good has an elastic demand or an inelastic demand?

• Think about the goods you know and see whether this matches up to reality...

The notion of unit cost and profit

Rearranging this term, we have

Pz=(Pm*m)/z +w/z+rk/z

Price= unit material cost+unit wage cost+unit profit

Unit profit is sometimes called markup

r (Pzef ) (Pmm) w

k

The movement towards average profits

• Consider an industry where Pz is so high that rk/z is higher than in other industries,

• Other firms will enter, reducing Pz and competing away

• So there is a tendency for money and investment to flow into higher profit industries, lowering the relative profit there and increasing the relative profit in others.

• Tendency to equalize profit rates across industries!

Breakthroughs

• A breakthrough is something new—a new product, a new way of recruiting labor, a new technology, or anything innovative that gives one firm an advantage over its rivals.

• Metaphor: Price competition like trench warfare, Breakthroughs are like tanks

Examples of breakthroughs

• New, more productive technology

• New product• Better quality product• Rearrangement of

production• Use of different and

more productive (or cheaper) labor

r(Pzef ) (Pmm) w

Pc 1u c

Third form: Reduce Competitive Pressures

• Obtaining Monopoly Power You can obtain proprietary rights and patent rights (software/medicine)

• This could also happen because of increasing returns to scale (remember?)

• Some industries have large barriers to entry—technical secrets, large exclusive marketing arrangements, high initial investments etc.

Oligopoly/Cartelization

• Cartels—illegal, but common—regulate the production and pricing of output

• Sometimes this agreement is tacit and not explicit– firms then do not cut prices for fear of a price war and instead compete on other dimensions (sales for example)

Quote from...?

• People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.

Investing to compete..

• All three forms of competition force firms to put away some profits in order to compete in the next period

• In order to maintain or increase profit rate, firms invest (in new technologies, buying privileges etc.)

• The idea is to obtain dynamic competitive advantages (consider fig 11.2)

How to decide when to invest

• Let i refer to the cost of buying new equipment, hiring new scientists etc. We can think of this as the cost of borrowing money from the bank for this purpose (sometimes it is called the interest rate)

• Let re be the expected rate of profit on the investment.

• Then firm should invest if re >I• re depends on sentiment!

Interest rates and investment

• Now this means something quite interesting. The amount of investment and the amount of growth in the economy could depend on not on what the firm thinks it could get in terms of return, but also the interest rate.

• If interest rates are low, incentives to invest are higher and probability of growth/competition are higher

Equalization of Profit Rates?There is a tendency for funds to flow into industries where profit rates are high lowering relative profits..

How much concentration in each industry though?

• Economic Concentration: the extent to which the economic activity of an industry is conducted by a large number of firms.

• In the previous diagram, the supply might be increased by the entry of one firm, or 10,000 firms.

• Answer: it depends on the characteristics of the industry

Advantages of Size

• Size allows you to:

• A) Spend more money on breakthroughs

• B) Market more effectively

• C) Lobby more effectively for advantages

• D) Become larger by buying out competitors

• E) Enter new and connected markets more effectively (consider Time Warner)

But in certain industries...

• A) lower barriers to entry

• B) Non increasing returns to scale

• C) Newer industries so not so much entrenched political hold

• D) New and improved technologies are easier to come by and therefore displace established companies

• E) International Competition has increased

On balance

• Concentration has decreased marginally in the US since 1980. It is a more competitive economy.

• Yet, many industries in which there is high concentration.