Market Structure I: Perfect, Ricardian, and Williamsonian markets

1. Market Structure I:Perfect, Ricardian, and Williamsonian markets Paul C. Godfrey Mark H. Hansen Marriott School of Management

2. 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

3. Perfectly competitive markets

4. 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 Perfect competition: Assumptions

5. Determining Equilibrium Price and Quantity Industry vs. Firm ACff P P Sind MCff Pind Pind = Pff D=MR Dind Q Q Qind Qff Market Equilibrium Firm Equilibrium

6. Determining Equilibrium Price and Quantity Market Adjustment ACff ACind P P MCff MCind Pind1 D=MR Pind2 D=MR Q Q Qff Qind

7. Determining Equilibrium Price and Quantity Industry Costs and Supply ACind • 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 MCind $ P Industry supply curve Quantity

8. 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 Consumer Surplus Perfect competition: Social results $ Industry supply curve P* D0 Quantity

9. Ricardian markets

10. 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)

11. 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 A Ricardian corn market Corn output/ $ Rent Oc Units in production Marginal plot of land Oc—the opportunity cost of putting the land to the plow

12. 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 Consumer Surplus Producer Surplus Ricardian markets: Social results S0 $ P* D0 Quantity

13. 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!

14. Williamsonian Markets: The role of transaction costs

15. 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

16. 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)

17. K = level of asset specificity DC= differential cost of in-house production DG= differential cost of governance in-house The make or buy decision Cost DC + DG DC DG k* k’ k

18. 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

19. Markets with externalities

20. 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 The problem of externalities SMCN MCP SMCP $ P QP QSP QN Quantity

21. 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