INDUSTRIAL ECONOMICS I

1. INDUSTRIAL ECONOMICS I Concentration andProfitability

2. Introduction • 2 views. • 1.Many economists favor the view of building up monopoly power (e.g. through merger.) • Even if it has the advantage in creating economies of scale and has the potential of exploiting consumers. • This is also the view of the US authorities.

3. Introduction • The European view is more ad hoc. • Each merger proposal is taken based on its merit. • The authorities will decide based on its net advantage to the society. • The concern is on the increase in concentration allowing prices to raise higher cost. Hence, increase in profits. • If profits are greater than opportunity cost, there is no gain to society. • The link is from concentration to profit.

4. Introduction • Demsetz (1973), however, said that this is not the case. • The causal link is not from concentration to profitability. • The link is from efficiency to concentration and efficiency to profit.

5. Demsetz – Monopoly Power. • Assume that there is constant unit costs, so there is no economies or diseconomies of scale. • Therefore marginal cost is equals average cost. • Suppose there are a number of firms in the industry. • Each firm faces downward sloping demand curve. – firms restricts output and raises price above marginal cost.

6. Demsetz – Monopoly Power. The diagram shows price is charged at P1. Firm makes abnormal profit by producing at Q1. Total revenue is at OQ1 x 0P1. Total cost is output times MC, i.e. OQ1 x Q1B. Thus, profit above normal is OQ1 x AB. Suppose firm improves cost efficiency through R&D and produce output at lower cost. No other firms got the technology, therefore the firm has lower cost structure than other firms. Originally MC1=AC1, now MC2=AC2 Profit maximizing output is OQ2 at price P2. Price and cost P1 A S P2 MC1 = AC1 B R MC2 = AC2 MR D 0 Q1 Q2 output

7. Difference in View • The first view links concentration to profit. • Demsetz disagrees. What has enable firms to raise profits is superior efficiency. • The effect of superior efficiency makes volume of output larger • Another important effect is that firms make more profit. Total profit is OQ2 x OP2.

8. Demsetz’s View • According to Demtsez, the superior efficiency also leads to concentration. • Firm produced higher proportion of industry output than before at the same time making more profit. • Profit is a reward towards increase in efficiency.

9. Demsetz’s View • Increase in profitability is temporary. • Technology, over time will be diffused throughout the economy. • High profit in the industry will attract new entries into the market which will also be able to develop superior techniques. • Over time all firms in the industry will be using superior techniques

10. Demsetz’s View • Increase in concentration without government intervention is temporary. • Unless firm with market power keeps price to the level where only normal profit is earned.

11. Demsetz’s View • Increase concentration is good. • Increase in profitability is also good. • Consumers are not being exploited. • Increase in efficiency will benefit consumer in the long run. • This is a relaxed view about link between concentration profitability and market power.

12. Demsetz’s View CR4 Number of R1 R2 R3 R4 R industries % % % % % 10-20 20-30 30-40 40-50 50-60 Over 60 14 22 24 21 11 3 7.3 4.4 5.1 4.8 0.9 5.0 9.5 8.6 9.0 9.5 9.6 8.6 10.6 9.9 9.4 11.2 10.8 10.3 8.0 10.6 11.7 9.4 12.2 21.6 8.8 8.4 8.8 8.7 8.4 11.3 CR4: four-firm concentration ratio measured on industry sales in 1963 R1: firms with assets < US$500,000. R2: firms with at least US$500,000 assets but < US#5 million. R3: firms with at least US$5 million assets but < US$50 million. R4: firms with assets > US$50 million. Source: Densetz (1973) p.6, Table 2.

13. Demsetz’s View • Consider a CR4 Table. • a number of industries with different degrees of concentration. • Rates of return (ROR) of firms of various sizes are given for each group. • E.g.14 industries with CR4 is between 10-20% ROR on assets to the smallest firms (R1) averaged 7.3%. • CR4 of over 60% there is only three such industries.

14. Demsetz’s View • In general the relatively unconcentrated industries the variation in the ROR as firm size increase is quite small. • Moving towards a more concentrated structure the difference between ROR made by small firms and ROR made by big firms is getting bigger.

15. Demsetz’s View • 2 ways to explain the findings: • 1. one possibility is that the larger firms in more concentrated industries are getting additional profits by; • By the use of market power • Establish some kind of agreement • Cartels among themselves. • Large firms use their power to exploit consumers by agreeing price above cost causing increase in concentration and profitability.

16. Demsetz’s View • 2. superior efficiency of the larger firm driving down cost, causing increase in concentration and profitability. • Demsetz disagrees with the first reasoning. • It cannot be large firm getting together to agree on price and driving price above costs, because the smaller firms will also benefit. • Hence, smaller firms ROR will also increase.

17. Demsetz’s View • He concluded that higher ROR and greater profitability of the bigger firms is not due to collusion but because of higher efficiency. • The process which the firm and consumers will gain in the long run. • Scherer (1970) however, agrees with the earlier alternative link from concentration to profitability.