New Developments in the Analysis of Market Structure

This paper presents an approach to the theory of monopolistic competition which owes a particular intellectual debt to Gorman (1980), Kaldor (1934; 1935) and Lancaster (1966). Our interest is in deriving testable hypotheses from partial equilibrium analysis. Some simple conceptual experiments, in conjunction with some awkward facts, lead us to take strong positions concerning the appropriate demand and cost primitives. The choice of primitives has important implications for the concept and the properties of equilibrium. We hope that the approach presented here is coherent; but it has to be said that the analysis has not been completed, by ourselves or anyone else. Part of our purpose is accordingly to note unsolved problems, and generate an agenda for further research. At some points we are able only to offer a conjecture as to what the results of further research may be. We confine ourselves throughout to the market for consumer goods (Chamberlin’s, 1933, problem) and do not consider the markets for capital, labour or intermediate goods.

In the struggle to create, maintain and expand favourable market positions, firms’ actions are intended not only to affect the current conduct of rivals directly, but also to have an indirect effect by altering market structure in a way which constrains the rival’s subsequent actions. In this dynamic process, market strategies or conduct (the control variables) interact with market structure (the state variable); and current conduct can become embedded in future market structure through strategic investments made by firms to bar entry and reduce intra-industry mobility. (For an analysis of this view of industry dynamics, see Jacquemin, 1972; Caves, 1976, Part I; Caves and Porter, 1977; Spence 1981a, p. 51; and Stiglitz, 1981, p. 187). Of course, not all investments made by firms have the intended effect on market structure, and the purpose of this survey is to consider a recent body of literature which has devoted itself to precisely this point.¹ This work is of interest because of the new light it has shed on the combined structural and strategic origin of market power; that is, on the hoary question of the persistence and profitability of dominant firms (compare Posner, 1972, p. 130 with Williamson, 1975, p. 218 for contributions to this old debate). The literature seems to have coalesced around two basic types of model.

That vertical integration is to be understood in large measure as a transaction-cost economising outcome has been generally conceded since Ronald Coase advanced the argument in 1937.² The argument was forcefully restated by Kenneth Arrow as part of his assessment of the market failure literature (1969, p. 48). It was not, however, until 1971 that the underlying mechanics were described (Williamson, 1971). The argument has since been elaborated (Williamson, 1975, 1979; Klein, et al., 1978). Of equal if not greater importance, the same underlying transaction cost reasoning applies broadly — which is to say that vertical integration is a paradigm problem. Such apparently unrelated phenomena as the employment relation, aspects of regulation, vertical market restrictions, and even family organisation³ are variations on a theme.

Four incentives for the vertical integration of firms have frequently been mentioned in the literature. Mergers may result from market power in either the primary-resource, intermediate-product or final- product markets.¹ Technological advantages accruing to combination can arise through increasing returns,² information advantages³ or decreased transactions costs, when firms place themselves in a cooperative rather than an adversarial relationship.⁴ Tax avoidance provides a third reason for integration.⁵ More generally, integration opens up a wider range of strategies in the face of regulation and more flexibility in implementing them. Finally, imperfections in the market for the intermediate product may lead firms to combine in order to bypass these problems by transferring goods internally.⁶ This chapter addresses the last of these issues. In particular, it studies the problem of price inflexibility in an intermediate-product market which is beset by stochastic demands, and the temporary shortages and gluts of this product that result. We hypothesise that firms choose to integrate if the expected profit from doing so exceeds that of the separate divisions acting independently. Both descriptive and normative conclusions regarding such an industry are drawn on the basis of the model presented.

Anti-trust policy in the United States and other countries towards vertical restrictions on distribution (restrictions placed by manufacturers on retailers’ prices and quantities), has been fragmented and unsettled. This is, in part, because of a lack of consensus on what these restraints represent. On the one hand, vertical restraints have been explained as devices of monopolistic control of cartel coordination. On the other, restraints have been viewed as devices that can be used as purely vertical instruments to implement ‘efficient’ forms of distribution.

The literature on oligopolistic competition abounds with various implicit statements about the ‘stability’ of collusive arrangements. A well known example is provided by comments on price arrangements between the sellers in a given industry. It is asserted that any oligopolistic configuration must be unstable with respect to monopolistic collusion: ‘the combined profits of the entire set of firms in an industry are maximised when they act together as a monopolist, and the result holds for any number of firms’ (Stigler, 1950, p. 24). At the same time however, it is recognised that ‘when the group of firms agrees to fix and abide by a price approaching monopoly levels, strong incentives are created for individual members to chisel — that is, to increase their profits by undercutting the fixed price slightly, gaining additional orders at a price that still exceeds marginal cost’ (Scherer, 1980, p. 171). On the other hand, in the recent literature on the core of an exchange market, it has been shown that, sometimes, monopolistic collusion can be disadvantageous to the traders involved when compared to the competitive outcome (Aumann, 1973). As for the collusive price-leadership model, it is stressed that the outsiders of a merger agreement may be better off than the insiders:

the major difficulty in forming a merger is that it is more profitable to be outside a merger than to be a participant. The outsider sells at the same price but at the much larger output at which marginal cost equals price. Hence the promoter of a merger is likely to receive much encouragement from each firm — almost every encouragement, in fact, except participation (Stigler, 1950).

It is now well established in both the economic and legal literature that successful price co-ordination (either express or tacit) is not inevitable — even in highly concentrated industries protected by insurmountable barriers to entry. The key to this insight is the recognition that even though oligopolists’ fates are interdependent, individual self-interests are not perfectly consonant. As a result, oligopolists may find it difficult to agree on a mutually acceptable co-operative outcome, achieve that outcome smoothly, and maintain it over time in the face of exogenous shocks and private incentives to deviate. In the current language of industrial organisation, the joint profit-maximising point may not be a Nash equilibrium.

If the firm is maximising an objective function, its behaviour will depend on the type of that objective function. Basically, we can distinguish three simple cases which, of course, can be further elaborated. The firm maximises either a residual, usually called profit, or one or two ratios, namely, income per worker or profit per unit of capital. I shall denote the three cases as: the entrepreneurial firm, the Worker-Managed (or Illyrian) firm and the capitalist firm. In order to simplify the analysis, only two factors of production are assumed (labour and capital), and joint products are absent.

‘Competition: the condition prevailing in a market in which rival sellers try to increase their profit at one another’s expense … ’(McGraw-Hill, Dictionary of Modern Economics, 1965, p. 102). ‘Competition enters all major areas of man’s life and generally connotes rivalry between two or more men or groups for a given prize.’ (International Encyclopaedia of the Social Sciences, vol. 3, 1968, p. 181).

The purpose of this chapter is to provide an overview of the theory of perfectly-contestable markets.² The treatment here is deliberately schematic in order to focus on the logical structure of the theory.

Manufacturers take many actions designed to enhance the demand for their products. They generally deal with product design and packaging, price structures at wholesale and retail levels, training and deployment of sales personnel, and the economic and contractual dimensions of the distribution channels they employ. They may also engage in media advertising. Retailers generally engage in most of these same activities. Consumer purchase decisions are affected by many external stimuli. Consumers may take into account their own experience, the experiences of friends and relatives, conversations with sales people and other experts, data on relevant prices, and information about product attributes, obtained from a variety of public sources. Purchase decisions may also be affected by media advertising.²

It is now widely recognised that the nature of competition in market economies is far more complex (and more interesting) than the simple representation of price competition embodied in, say, the Arrow-Debreu model. Not only are there alternative objects of competition: firms compete not only about price but also about products and R & D. But, also, the structure of competition, the ‘rules’ which relate the pay-offs to each of the participants to the actions they undertake, may differ markedly from that envisioned in the standard model.²

In many markets, firms compete over time by expending resources with the purpose of reducing their costs. Sometimes the cost-reducing investments operate directly on costs. In many instances, they take the form of developing new products that deliver what customers need more cheaply. Therefore product development can have the same ultimate effect as direct cost reduction. In fact, if one thinks of the product as the services it delivers to the customer (in the way that Lancaster pioneered), then product development often is just cost reduction.

It is not self-evident that economists ought to engage in the task of explaining the characteristics of technological innovations. It is even less evident that development and inventive activities are related to the structure of economic organisations. Or so it would seem from the near-complete absence of a discussion of such issues in resource- allocation theory.² So would it seem, as well, from the sheer volume of effort that has been spent over the past quarter of a century in trying to demonstrate that economic forces are a prime architect of technological change.³ If there is a single driving force behind these empirical investigations, it is the writings of Joseph Schumpeter (most especially perhaps his Capitalism, Socialism and Democracy, Schumpeter, 1976). Since recent developments in the theory of technological competition have addressed a few of the empirical findings, they reflect this heritage as well.