Archive

Archive for the ‘Market Structures’ Category

Sunk Costs, Market Structure and Football Clubs

January 19, 2017 Leave a comment

Over the holidays I read Stefan Szymanski’s book “Money and Football – A Soccernomics Guide”. Szymanski also co-authored “Soccernomics” with Simon Kuper. There were various references to economic theory through the book which I will refer to on this blog.

Market Dominance

Dominance in a market is often associated with the lack of competition whether it be due to monopoly power, predatory pricing, the scale of investment etc. However this is not the case when it comes to football. Szymanski mentions the fact that there are 27 professional teams withn a 50 mile radius of Manchester Utd. If fans don’t like United, there are plenty of alternatives as there are in Madrid which has 5 professional clubs. In some countries football rivals play in the same stadium:

  • In Germany: Bayern Munich and TSV 1860 Munich,
  • In Italy: Inter Milan and AC Milan,
  • In Switzerland: FC Zurich and FC Grasshopper
  • In Brazil: Botafogo, Flamengo and Fluminense

Football Clubs.jpgDominance in markets usually occurs because of the initial investment required to compete in the first place – set-up costs. If you look at the railway industry (which could be said to be a natural monopoly) the cost of putting down new train tracks by the existing ones or a new line would be excessive and the ability to cover these costs would very difficult. Any benefit that may arise from competition would be diminished by the cost of duplication.

Dominance is easy to explain if there are very large set-up costs, which, once spent, cannot be recovered other than by operating in the industry. Economist refers to these costs as Sunk Costs.

Dominance in a market can also occur in markets where there are less sunk costs. Take for instance the soft drinks industry as an example. It remains relatively inexpensive to set-up a production plant to bottle soft drinks but Coca-Cola dominates the world market with 42% market share, followed by Pepsi with 28%. Their dominance is through advertising which makes up the majority of the sunk costs. Advertising is an example of ‘endogenous’ sunk costs which are determined by the firm as opposed to ‘exogenous’ sunk costs which are determined by technological requirements.
Premier League Players.jpgIn professional football the focus is on player investment rather than advertising, where the big clubs are those that spend heavily on players and win league championships. Teams that win are more likely to attract a larger fan base and greater revenue. Szymanski states that the big difference between football and soft drinks is that the pattern of dominance looks the same in small markets. For instance clubs in the English Division 2 (Division 4 in the old days) still stay in existence mainly because they operate in a different market than the Premiership teams. Of the 88 clubs in the English Football League in 1923, 85 still exist, and most of them still play in the 4 English Divisions. Also those clubs in the lower Division do benefit from intense local loyalty especially through tough times with performance. When clubs get relegated to the Championship from the Premier League, although they lose revenue from TV rights their fan base remains fairly constant. However a lot of these clubs will find it hard breaking into the dominant group – Manchester City, Manchester Utd, Liverpool, Arsenal, Chelsea, Spurs – unless they receive significant funding from an investor who doesn’t expect to see a financial return or have an exceptional season without high profile players like Leicester City who won the Premiership in 2015/16.

Unlike most business in which loss-making firms shut down or merge into other businesses, football clubs almost always survive. This does not prevent dominance, but unlike most industries, it does mean that the pattern of dominance tends to look the same everywhere. Source: Szymanski

Monopsony v Monopoly – Tesco v Unilever

October 17, 2016 Leave a comment

Geoff Riley did a very good post on Tutor2u that outlined the recent dispute between Tesco and Unilever. Marmite, PG Tips tea and Pot Noodles are among dozens of brands currently unavailable on Tesco’s online site due to this dispute with Unilever. Unilever raised its price by 10% in the UK to compensate for the sharp drop in the pound’s value.

Tesco is resisting the move and has removed Unilever products from its website. Unilever see the price increase as a  “normal” reaction to shifts in currency values – since the Brexit vote there has been a 17% decrease in the value of the pound which has added to the cost of importing goods. The products currently absent from Tesco’s website also include Comfort fabric conditioner, Hellmann’s mayonnaise and Ben & Jerry’s ice cream. With the A2 exam looming here are some notes on Monopoly and Monopsony.

Monopoly and Monopsony theory

Monopoly. Perfect competition is not to be found in the real world and absolute or pure monopoly is also virtually impossible to achieve since it applies operating in the absence of competition (i.e. no substitutes). While it is not difficult for a firm to become a sole supplier it is extremely difficult to achieve a situation where there are no substitutes for the product. A more realistic definition of monopoly would be ‘a sole supplier of a commodity for which there are no good substitutes’. In fact the degree of monopoly power in the real world tends to be judged on the basis of the share of the total market accounted for by any particular supplier.

The graph below shows that at profit maximising equilibrium, output Qm is less than that in a competitive market (Qe), and the demand and supply (MC) curves do not intersect. Qe represents the Allocative Efficiency level of output and Pe the price. The shaded area therefore represents the loss of allocative efficiency or the deadweight loss.

monopoly-dwl 

Therefore monopolists restrict output and mis-allocate resources leading to a deadweight loss to the economy. However the government, using price controls, can force a shift from the preferred monopoly equilibrium (MC=MR) to one equivalent to the perfectly competitive equilibrium (MC=AR). At the less-preferred equilibrium, a monopolist’s supernormal profit may be either reduced or turned into a subnormal profit. In the latter case, a permanent subsidy may be necessary to keep the firm in business.

Monopsony. Two areas are worthy of mention, including the monopsony power of the large supermarkets (as stated above), who can dictate terms to smaller suppliers, and the monopsony power associated with buyers of labour in the labour market.

A monopsony occurs in the labour market when there is a single or dominant buyer of labour. The buyer therefore is able to determine the price at which is paid for services. Unlike other examples we have looked at, in this situation we are now dealing with an imperfect rather than a perfectly competitive market. The monopsonist will hire workers where:

monopsony-labour

Marginal Cost of labour (MCL) = Marginal Revenue product of labour (MRPL)

You will remember from the notes on the Perfect Labour Market that this is known as the profit maximising position.

From the perspective of the monopsonist firm facing the supply curve directly, if at any point it wants to hire more labour, it has to offer a higher wage to encourage more workers to join the market – after all, this is what the ACL curve tells it. However, the firm would then have to pay that higher wage to all its workers so the marginal cost of hiring the extra worker is not just the wage paid to that worker, but the increased wage paid to all workers as well. So the marginal cost of labour curve (MCL) can be added to the diagram.

If the monopsonist firm wants to maximise profit, it will hire labour up to the point where the marginal cost of labour is equal to the marginal revenue product of labour. Therefore it will use labour up to level of Eq which is where MCL=MRPL. In order to entice workers to supply this amount of labour, the firm need pay only the wage Wq. (Remember that ACL is the supply of labour). You can see, therefore, that a profit-maximising monopsonist will use less labour, and pay a lower wage, than a firm operating under perfect competition.

In this situation the power of the employer in the labour market is of overriding importance and the employer can set a low wage because of this buying power.

A2 Economics Revision: Contestable Markets

October 5, 2016 Leave a comment

Contest MarketsIn the A2 course contestable markets is a popular essay question and is usually combined with another market structure.

What is a contestable market?

• One in which there is one firm (or a small number of firms)
• Because of freedom of entry and exit, the firm faces competition and might operate in a way similar to a perfectly competitive firm
• The threat of “hit and run entry” from new firms may be sufficient to keep the industry operating at a competitive price and output
• The key requirement for a contestable market is the absence of sunk costs – i.e. costs that cannot be recovered if a business decides to leave a market
• When sunk costs are high, a market is more likely to produce an price and output similar to monopoly (with the risk of allocative inefficiency and loss of economic welfare)
• A perfectly contestable market occurs only when entry and exit into and out of a market is perfectly costless
• Contestable markets are different from perfect competitive markets
• It is possible for one incumbent firm to dominate the industry
• Each existing firm in the market produces a differentiated product (i.e. goods and services are not perfect substitutes for each other)

There are 3 conditions for market contestability:

• Perfect information and the ability and or legal right to use the best available technology
• Freedom to market / advertise and enter a market
• The absence of sunk costs

Example
• Liberalisation of the European Airline Market in late 1990s
• Traditional “flag-flying” airlines faced new competition
• Barriers to entry in the industry were lowered (including greater use of leased aircraft)
• New Entrants – easyJet- Ryanair

Sunglasses – a true monopoly.

August 17, 2016 Leave a comment

With summer approaching in the southern hemisphere and the days getting brighter you will be looking to don sunglasses on a more regular basis. Sunglasses come in various styles and brands, eg. Rayban, Oakley, Gucci, Prada, Versace to name but a few,  but can be quite expensive when you consider the so-called competition that is in the market which in theory should driving down the price. Sunglasses these days are reasonably homogeneous in that the frames and materials are very similar and it surprised me that 80% of the major sunglass brands are controlled by Luxottica, in a market that is worth US$28 billion.

Luxottica produced the following brands of sunglasses under their name:

Prada, Chanel, Dolce & Gabbana, Versace, Burberry, Ralph Lauren, Tiffany, Bulgari, Vogue, Persol, Coach, DKNY, Rayban, Oakley, Sunglasses Hut, LensCrafters, Oliver Peoples, Pearle Vision, Target Optical and Sears Optical.

This list of brands is fairly comprehensive and by controlling 80% of the market you have a monopoly and dictate the price consumers have to pay for each specific brand since the industry isn’t competitive. Therefore they are Price Makers. But Luxottica also dictate what goes in the shops as they own Sunglass hut, Oliver peoples and Pearle Vision where consumers shop for sunglasses. This makes it very difficult for a brand outside one that is produced by Luxottica to compete as you can’t get your product into those shops. So not only do they have a monopoly in the production but they also control the distribution of sunglasses. See monopoly graph below.

Monopoly

In the clip below from ’60 Minutes’ they mention Oakley’s dilemma when their sunglasses became more popular than those produced by Luxottica. When this happen Luxottica proceeded to hold fewer Oakely sunglasses in their Sunglass Hut shops causing Oakley’s stock to plunge. Then in 2007 Oakley was left with no choice but to merge with Luxottica.

 

 

Categories: Market Structures Tags:

Ludicrous regulations of the US Airline Industry and Contestable Markets

August 12, 2016 1 comment

We discussed Contestable Markets in my A2 class today and I used this clip from Commanding Heights to show how regulated the US airline industry was during the 1970’s. Regulations meant that major carriers like Pan Am never had to compete with newcomers. However an Englishman named Freddie Laker was determined to break this tradition and set-up Laker airways to compete on trans-atlantic flights. He offered flights at less than half the price of what Pan Am charged. Alfred Kahn was given the task by the then President Jimmy Carter to breakup the Civil Aeronautics Board (the regulatory body) and he wanted a leaner regulatory environment in which the market was free to dictate price. There is a piece in the clip that shows how ludicrous some of the regulations were:

When I got to the Civil Aeronauts Board, the biggest division under me was the division of enforcement – in effect, FBI agents who would go around and seek out secret discounts and then impose fines. We would discipline them. It was illegal to compete in price. That means it was illegal to compete in the discounts you offer travel agents. So we regulated travel agents’ discounts. Internationally, since they couldn’t cut rates, they competed by having more and more sumptuous meals. We actually regulated the size of sandwiches. Alfred Kahn

When the CAB was closed down competition was the rule and the industry had vastly underestimated the demand for air travel at lower prices – a very elastic demand curve – see graph below.

 

 

 

 

 

 

 

 

In the A2 course contestable markets is a popular essay question and is usually combined with another market structure.

What is a contestable market?

• One in which there is one firm (or a small number of firms)
• Because of freedom of entry and exit, the firm faces competition and might operate in a way similar to a perfectly competitive firm
• The threat of “hit and run entry” from new firms may be sufficient to keep the industry operating at a competitive price and output
• The key requirement for a contestable market is the absence of sunk costs – i.e. costs that cannot be recovered if a business decides to leave a market
• When sunk costs are high, a market is more likely to produce an price and output similar to monopoly (with the risk of allocative inefficiency and loss of economic welfare)
• A perfectly contestable market occurs only when entry and exit into and out of a market is perfectly costless
• Contestable markets are different from perfect competitive markets
• It is possible for one incumbent firm to dominate the industry
• Each existing firm in the market produces a differentiated product (i.e. goods and services are not perfect substitutes for each other)

There are 3 conditions for market contestability:

• Perfect information and the ability and or legal right to use the best available technology
• Freedom to market / advertise and enter a market
• The absence of sunk costs

Example
• Liberalisation of the US Airline Industry in the 1970’s and the European Airline Market in late 1990s
• Traditional “flag-flying” airlines faced new competition
• Barriers to entry in the industry were lowered (including greater use of leased aircraft)
• New Entrants – easyJet- Ryanair

A2 Economics -Imperfect Competition with M&M’s

August 4, 2016 Leave a comment

Not to be outdone by my previous post, colleague Warren Baas had his A2 class use M&M’s to construct Imperfect Competition graphs. See the selection below – subnormal profit and normal profit.

Categories: Market Structures Tags:

A2 Economics – Teaching MC=MR with M&M’s

August 4, 2016 Leave a comment

Having just completed Perfect Competition with my A2 class I used a couple of packets of M&M’s to drum home the concept of marginal analysis MC=MR. It has always been something that students have struggled with but I am hoping this experience of creating graphs with M&M’s might help their understanding and when to use the concept.

Profit is maximised at the rate of output where the positive difference between total revenues and total costs is the greatest. Using marginal analysis, the perfectly competitive firm will produce at a rate of output where marginal revenue equals marginal cost. Marginal revenue, however, is equal to price. Therefore, the perfectly competitive firm produces at an output rate where marginal cost equals the price of output. Remember that the firm will make profits as long as the extra revenue brought in from selling the last unit of output(MR) is greater than the extra cost which is incurred in producing it(MC). Below are some of the graphs they created – perfect competition normal profit, subnormal profit, supernormal profit and the firm and the market for long-run perfect competition.
MM1 MMs2MM2 MM3

 

%d bloggers like this: