Market Structure I: Perfect, Ricardian, and Williamsonian markets Paul C. Godfrey Mark H. Hansen...
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Transcript of Market Structure I: Perfect, Ricardian, and Williamsonian markets Paul C. Godfrey Mark H. Hansen...
Market Structure I:Perfect, Ricardian, and Williamsonian markets
Paul C. Godfrey
Mark H. Hansen
Marriott School of Management
Why do these topics matter to strategists
• Perfect markets almost never occur, but form a strong analytical base case from which to draw comparisons
• Ricardian markets have a lot of real world features, and implications for formulating strategy
• Williamsons views of markets help managers make crucial decisions about vertical integration, diversification, and alliances
• Markets with externalities change the decision calculus
Perfectly competitive markets
Perfect competition: Assumptions
Product markets
• Differing tastes/ preferences/ needs
• Identical products
• Price-taking consumers
• Full information
• No uncertainty
• No externalities
Factor markets
• All assets completely tradable: identical products
• Price-taking sellers
• No scale economies
• Costless entry/ exit
• Full information
• No externalities
P P
Q Q
Dind
Sind
Pind
Qind
Pind = Pff
Qff
MCff
ACff
D=MR
Market Equilibrium Firm Equilibrium
Determining Equilibrium Price and QuantityIndustry vs. Firm
P
Q
Pind1
Qff
MCff
ACff
D=MR
P
Q
Pind2
Qind
MCind
ACind
D=MR
Determining Equilibrium Price and QuantityMarket Adjustment
• Market clears– No excess demand
• No economic profit– All sellers have same cost
curve– Entry/ exit stabilize price
• Industry supply schedule is flat
• Productive efficiency– All production most cost
efficient
$
Quantity
MCind
P
ACind
Industry supply curve
Determining Equilibrium Price and QuantityIndustry Costs and Supply
Perfect competition: Social results
• A market that clears leads to allocative efficiency
– All consumers, producers satisfied– Only consumers get surplus
• Productive efficiency– All production occurs at minimum
cost
• Pareto optimal– No one better off without someone
else worse off– All mutually beneficial trades
executed
$
Quantity
D0
P*
ConsumerSurplus Industry supply curve
Ricardian markets
The basics
• David Ricardo (1772-1823)
• Considers corn (grain) production in the British economy
• All assumptions the same as perfect competition except,
• Plots of land are of various quality for producing corn– Variations in quality inhere in the land (non-tradable or fungible)
– Differential quality is a fixed attribute
– Each plot of land requires the same amount of labor to work (marginal costs are equal)
A Ricardian corn market• Economic rent = the difference
between the market return of a piece of land and the return of the marginal plot in production
• Farms (firms) earn rents on unique, valuable, and rare assets.
• The most valuable farm (firm) will have the lowest average cost per unit of corn
Corn output/$
Units in production
Oc
Oc—the opportunity cost of putting the land to the plowMarginal plot of land
Rent
Ricardian markets: Social results
• A market that clears leads to allocative efficiency
– All consumers, producers satisfied– Consumers and producers get
surpluses
• Productive efficiency– All production occurs at minimum
cost (over total output)
• Pareto optimal– No one better off without someone
else worse off– All mutually beneficial trades
executed
$
Quantity
D0
P*
ConsumerSurplus
S0
Producer Surplus
Managing in (for) a Ricardian market
• Firms that can capture, create resources can earn rents– resources can heterogeneously distributed (rare) and immobile (costly
to imitate)
• Resources can be endowed, as in nature
• Resources can be developed through investment
– this is a critical point to the strategist!
Resources can be managed!
Williamsonian Markets: The role of transaction costs
Transaction costs
• In perfect markets there are no transaction costs, or costs (risks) of doing the deal
• In the real world, it takes time and money to do the deal, and there are risks
• Four types of transaction costs– Uncertainty—all outcomes are not known in advance
– Asymmetric information—some parties know more than others
– Opportunism—some actors transact with guile (deception, self-serving behaviors)
– Asset specificity—The difference in value between the designed use and the next best use
The make or buy decision
• A key decision for strategists is whether the firm should make critical inputs or buy them on the market
• Making it yourself is costly:– Loss of market incentives to hold costs down– Bureaucratic costs of supervision and governance
• Buying it on the market may be costly– Risk of opportunism impedes specialized asset investments– Costs of dealing with uncertain outcomes potentially high
• The critical question: When to make (integrate, acquire, alliance) and when to buy (contract)
The make or buy decision
K = level of asset specificity
C= differential cost of in-house production
G= differential cost of governance in-house
Cost
C
G
kk’k*
C + G
Managing in a Williamsonian world
• At low levels of specificity (below k*), the firm is better off to buy the input on the market
• At moderate levels of specificity (between k* and k’), the firm benefits from a joint-venture, alliance, or hybrid form of make-buy
• At high levels of specificity (above k’), the firm should integrate (acquire) the input and produce it in-house
Markets with externalities
The problem of externalities
• Externalities occur when the impacts of any transaction are not limited to the private parties involved
– Negative—pollution in the Grand Canyon, Airplane landings
– Positive—cool music, the value of MS Office
• Externalities represent costs (benefits) not factored into private (price) decision making
• Private decision rules will over-supply goods with negative externalities
• Private decision rules will under-supply goods with positive externalities
$
Quantity
MCP
P
SMCN
SMCP
QP QSPQN
Managing in a world with externalities
• A popular solution: internalize the externality through taxes– Pollution tax credits
• Externalities cannot be factored away, or claimed as “outside” of our concern
• Externalities force managers to consider the social costs/benefits of their actions