Structure Conduct Performance Paradigm ECN4181 – Industrial Economics Lecture 2
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Contents 2
Background Structure Conduct Performance SCP approach explained Relationships between structure, conduct and performance Neoclassical developments of SCP approach Case study: Entry barriers Testing the SCP: empirical evidence Measuring variables Defining markets and industries Developments of SCP approach outside Neoclassical theory Example: Food Security
Background
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Background Structure Conduct Performance (SCP) model postulates a casual relationship between the structure (S) of a market, the conduct of firms in that market (C) and their economic performance (P). The SCP: dates back to the work of E. Mason (1930s) and J Bain (1950s) is based exclusively on the neoclassical theory of the firm (i.e. perfect competition, monopoly and monopolistic competition, oligopoly) has long been central to the study of industrial organization. 4
Background The SCP: has been used to provide theoretical justification for competition policy – i.e. the SCP has provided the rationale for measures intended to modify (or to prevent) the development of market structures likely to promote behaviour and performance which is considered “detrimental” to the public interest. E.g. used by the US government in drafting antitrust policy
gained popularity among corporate strategists when Michael
Porter (Competitive Strategy, 1980) used it as an analytic tool for businesses striving to compete within a market
But SCP approach has been criticised on a number of counts,
including on the fact that it is based too exclusively upon neoclassical theory.
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Components of SCP What do we understand by Structure? What do we understand by Conduct? What do we understand by Performance? How do you measure Performance?
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What is Structure? STRUCTURE describes the characteristics and composition
of markets and industries in an economy. A. At its most aggregated level, it relates to the relative importance of broadly defined sectors of the economy. Industrial structure may be seen in terms of a three-sector
economy in which economic activity is classified as: PRIMARY, SECONDARY, TERTIARY
B.
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Structure can also refer to the number and size distribution of firms in the economy as a whole. E.g. largest firms by revenue / market capitalisation
Structure under the SCP Under the SCP, STRUCTURE relates to the importance and
characteristics of individual markets within the economy. Here structure describes the environment within which firms in a particular market operate.
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Structure - characteristics Principal structural characteristics: Market Concentration: number and size distribution of buyers
and sellers Extent of product differentiation/ substitution Ease of entry into the market/ barriers to entry/ exit conditions Extent of firm integration (vertical/ horizontal) or diversification Reminds us of Porter’s 5 forces model 9
Porter’s 5 Forces POTENTIAL ENTRANTS
SUPPLIERS
COMPETITION AND RIVALRY
SUBSTITUTES
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BUYERS
Conduct Conduct refers to the behaviour (actions) of the firms in a market,
to the decisions firms make and to the way in which decisions are taken. E.g. how firms set prices (whether independently or in collusion with
others in the market) how firms decide on their advertising how firms decide on research budgets, and how much expenditure is devoted to these activities plant investment, legal tactics, product choice, collusion, merger and contracts. These factors are often more difficult to identify empirically than
either structural or performance characteristics.
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Performance The economist’s concern is with the performance of firms.
The essential question is whether or not firms’ operations enhance economic welfare, i.e. how well firms satisfy consumer requirement in the current time period. Are they being productivity efficient? Are they being allocatively efficient?
To answer these questions, we look at aspects of performance
such as the relationship between prices and costs, and the level of profits earned.
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Performance Productive efficient - avoiding wasteful use of available
factors of production Allocative efficient - producing the “right” goods and in the
“right” quantities
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Performance Under conditions of perfect information, economic welfare is
maximised when the Pareto marginal conditions are fulfilled, i.e. where firms set Price = Marginal Cost. In the neoclassical model of perfect competition, firms maximise profits when price = Marginal Cost, and this results in a price and output combination that is both productive and allocatively efficient.
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Performance Inferior performance is expected in markets that match the
neoclassical models of monopoly, oligopoly or monopolistic competition. Although firms may be productively efficient, the level of output is unlikely to meet the requirements of allocative efficiency. This arises as firms in such markets possess a degree of market (or monopoly) power, i.e. they have some discretion in determining the price at which to sell their output. Unlike the model of perfect competition, they are able to raise price above the level of marginal cost. 15
Performance – Lerner index The Lerner Index (1934) or price-cost margin, presents a
theoretical measure of market power. See Lerner, A. P. (1934), "The Concept of Monopoly and the Measurement of Monopoly Power”
MARKET POWER - discretion in determining the price of
output to be sold. Price Marginal Cost and is in fact Price > Marginal Cost Measured by Lerner Index = (Price – Marginal Cost) / Price LI = 0 -> perfectly competitive firm I close to 1 -> greater market power
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Performance Therefore essential concern of the SCP approach has been
with effects on current economic welfare. However note that pricing/ profits are indications of
current/ past performance, hence yielding few insights into how well firms will perform in satisfying customer wants over time.
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SCP approach explained Performance is determined by the conduct of firms, which in
turn is determined by the structural characteristics of the market
Structure
Conduct
Performance
The linkage between structure, conduct and performance
then turns on matching the structural characteristics against the models of perfect competition, monopoly, monopolistic competition, and oligopoly. 18
SCP approach explained Example: We may use the SCP approach to contrast the structures of two different markets. Structural characteristics
Market 2
Number of firms
Many, each with small market share
Four (4), similar market shares
Number of buyers
Many
Few
Nature of product
Homogenous
Differentiated
Entry barriers
Low
Substantial
Conclusion?
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Market 1
SCP approach explained Example: We may use the SCP approach to contrast the structures of two different markets. Structural characteristics
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Market 1
Market 2
Number of firms
Many, each with small market share
Four (4), similar market shares
Number of buyers
Many
Few
Nature of product
Homogenous
Differentiated
Entry barriers
Low
Substantial
Conclusion?
Perfect competition
Oligopoly
SCP approach explained – market 1 Market 1 = Perfect Competition characteristics. Using SCP we can make deductions about conduct: Large number of competitors leaves firms with no choice but to act independently in determining price and output levels. Individual firms will be unable to influence the price determined by the market They have no reason to depart from this market-determined price Price will tend towards MC In the long run, firm will earn normal profits Production is therefore productive and allocative efficient, to the greater benefit of current economic welfare 21
SCP approach explained – market 1 Use of SCP for Market 1: Straight-forward chain of reasoning Gives clear guidance to policy-makers - Performance can be improved by actions designed to influence the structure of the market. In this case (market 1 but also under monopoly), there is no need to analyse the conduct – performance can be predicted directly from a consideration of market structure – structural conditions yield sufficient information to deduce how firms MUST behave. 22
SCP approach explained – market 2 Market 2 = Oligopoly. Deductions about conduct: Small number of equal-sized firms suggests that price, advertising and other aspects of firm behaviour are likely to be decided collusively. Thus this leads to higher price and lower output compared with Market 1. But the structure of the market does not guarantee collusive behaviour as the oligopolists may compete for increased market share with the result that price is kept close to the perfectly competitive level, hence giving an acceptable level of economic performance. Hence, using SCP here, only limited conclusions can be drawn. Analysis of conduct is an essential component of the SCP approach in oligopolistic markets. 23
SCP approach explained – market 2 Use of SCP for Market 2: But the structure of the market does not guarantee collusive behaviour as the oligopolists may compete for increased market share with the result that price is kept close to the perfectly competitive level, hence giving an acceptable level of economic performance. Hence, using SCP here, only limited conclusions can be drawn. Analysis of conduct is an essential component of the SCP approach in oligopolistic markets. 24
SCP approach explained - summary Structure
Conduct
Performance
Perfect competition
Profit maximisation No advertising
Allocatively efficient
Monopolistic competition Profit maximisation No advertising
Allocatively inefficient
Oligopoly
Allocatively inefficient
Monopoly 25
Possible profit maximisation Advertising and other non-price competition Possible profit maximisation Some advertising
Allocatively inefficient
Critiques of the SCP approach The following criticisms have been levelled at the SCP approach: SCP draws on microeconomic theory from which to examine the empirical
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behaviour of firms. However, economic theory does not always give us exact relationships between structure, conduct and performance. E.g. oligopoly theory can be seen as largely indeterminate, not generating any clear deductions. Structure can be measured by a multitude of indicators – but there is overemphasis on concentration. SCP is concerned with static short run equilibrium (a snapshot). What about the evolution of structural variables? How do conduct and performance influence future changes? Which variables belong to structure, which to conduct and which to performance? E.g. advertising, vertical integration, diversification Difficulties in measuring many of the variables (e.g. profitability, entry barriers, rate of entry?) What do we mean by performance? Profits? Variability in profits?
Relationships between structure, conduct and performance The traditional premise that market structure is exogenously
determined is unsound. Performance – and more particularly conduct – affect structure. E.g. mergers directly affect the number and size distribution of firms
in the market; E.g. innovation and advertising may raise entry barriers; E.g. predatory pricing could force competitors out of the markets.
If market structure gives rise to conduct which raises prices and
enhances profits, then this may attract entry, modifying the structure of the market. Also, various structural elements are unlikely to be independent, so that, for example, market concentration is likely to bear some relationship to the height of the entry barriers. 27
Relationships between structure, conduct and performance Hence the SCP may be adapted to incorporate more complex
linkages, although the essential causality still flows from structural criteria.
Structure
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Conduct
Performance
Neoclassical developments of SCP approach One of the criticisms of the SCP is that it is too loosely
derived from its theoretical underpinnings, and this has led to attempts to link the SCP more rigorously back to neoclassical theory.
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Neoclassical developments of SCP approach – contestable markets In Contestable Markets: An Uprising in the Theory of Industry Structure,
Baumol (1982) presented his notion of CONTESTABLE MARKETS, which implies that a particular market structure does not necessarily equate with a particular type of performance. Markets are contestable where the costs facing new entrants are similar to those of firms already in the market and where a firm leaving the market is able to salvage its capital costs (minus depreciation), i.e. there are no sunk costs. Under this view there are no entry or exit barriers, so monopoly profits cannot exist. The mere threat of entry forces existing firms to minimise their production and distribution costs and, thereby, to influence the structure of the market. Hence contestability automatically ensures that good performance results regardless of the structure that emerges. 30
Neoclassical developments of SCP approach – contestable markets In practise few markets are perfectly contestable, however there are
degrees of contestability. With lower barriers to entry and exit, the market will be more contestable. Contestable markets are likely to have competitive prices and low profitability.
Example –Walking Tours It is quite easy to enter this market: Buy yourself a nice sign and wait on the main street for tourists to pay you.
As long as you can speak for an hour on the subject matter you can enter the market. If you find the market is no longer profitable, you can leave with no set up costs. Therefore in theory, there is scope for hit and run competition. The authorities could create barriers to entry by introducing the necessity to get a permit to offer walking tours. For example, in Venice the number of licensed gondolas is strictly limited meaning they can charge high prices without threat of competition. 31
Neoclassical developments of SCP approach – contestable markets Example – Airline industry Assume there are just two airlines flying a particular route. If entry and exit were costly, the market would not be contestable and the two incumbent airlines might realize substantial economic profits from their protected market position. But in fact additional airlines can enter and leave this particular segment
of the air transportation market with minimal cost. The reason is that the relevant capital equipment - the airplanes themselves -- are highly mobile. Hence, if an additional airline were to enter and find this route to be unprofitable, it could simply "pull out" by flying its equipment to some other route. The awareness of the possibility of costless entry will compel the two airlines currently flying this route to provide their transportation services efficiently and at prices which yield only a normal profit.
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Neoclassical developments of SCP approach – contestable markets Example – Software industry It has been argued that the software market is a contestable one: entry and exit are virtually costless. What are the costs (if any) of entry into the word processor market? What about the costs of developing a new web browser? In other industries this was deemed to be the case - see Gillette case below
"In U.S. v. The Gillette Company and Parker Pen Holdings, the
government argued that entry was unlikely due to the brand name barriers as well as the time required to design and manufacture a pen. The government's expert argued further that product repositioning was unlikely, sunk costs were large, and consumer loyalty reduced the disciplining effects of entry. In contrast, Carl Shapiro, the parties expert argued that entry barriers were low. The judge agreed that entry barriers were low.”
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Neoclassical developments of SCP approach – contestable markets Example – Airline and software industries Mergers within industries such as banking, telecommunications, and airlines have created a stir among consumers who argue that economic freedom and efficiency are being sacrificed in favour of corporate profits. The theory of contestable markets postulates that firms in imperfectly competitive markets may act as though they operate in a purely competitive market when entry and exit are perfectly (or nearly) costless. Firms generate a normal profit when faced with the threat of additional market entrants As a result, consumers can continue to enjoy the lower prices that accompany competition. The merger between firms and subsequent strengthening of business concentration may not have detrimental effects on consumers. The United States Department of Justice has used this theory on antitrust cases to rule in favour of the defendant.
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Neoclassical developments of SCP approach – efficiency In Industry Structure, Market Rivalry and Public Policy, Demsetz
(1973) (Chicago School) came to a similar conclusion in suggesting that high profits may be a sign of efficiency not market power! Since in any market, the firm with the lowest costs will tend to increase in size and market share over time, there will be a tendency for market concentration to increase but, at the same time, there will be pressure on all firms to be efficient. Consequently, Demsetz argues that market structure will develop into that which enables production and distribution to be undertaken at least cost. 35
Neoclassical developments of SCP approach – focus on conduct For proponents of the new industrial organisation (e.g. Price-
Cost Margins and market structure, Cowling and Waterson, 1976), SCP needs to be integrated more closely and rigorously to neoclassical theory by moving away from the emphasis on structure and focusing on CONDUCT. They argue that CONDUCT is the key element not structure, and conduct interacts both with structure (through choice of output level) and with performance. However the structural measure of market concentration is still given a central role.
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Neoclassical developments of SCP approach – revised (dynamic) model In the 1980s, McKinsey Consulting suggested an extension
that added a dynamic element to a static framework. The dynamic version suggests that the relationships among structure, conduct, and performance are not unidirectional; they flow in the opposite direction, too. This approach allows companies to consider the influence of their own conduct on an industry's structure and, ultimately, on their own performance. Many companies use the revised model to "play through" various scenarios that might affect them, to gain an understanding of what's happening in their industries, and to develop their strategies. 37
Neoclassical developments of SCP approach – case study: entry barriers Even if we accept that structure determines performance in
some predictive way, SCP’s validity is undermined unless we agree over which structural characteristics are important or how the presence of particular characteristics is to be interpreted. Let us consider ENTRY BARRIERS, which enable established firms to earn abnormal profits over the long run.
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Neoclassical developments of SCP approach – case study: entry barriers ENTRY BARRIERS (based on work by Bain, 1956, in Barriers to
New Competition) defined as anything which places potential entrants at a competitive disadvantage with established firms, so that established firms are able to earn abnormal profits over the long run. Bain identified three main types of barriers: absolute cost (e.g. patents, access to superior resources, lower-cost
finance) economies of scale (even if cost functions are similar, since new entrant may operate at a scale which is too small to realise fully potential cost advantage) product differentiations (existing products have built up customer goodwill; new entrants therefore have to spend more on promotion) 39
Neoclassical developments of SCP approach – case study: entry barriers Stigler (Chicago School) argues that entry barriers are
incurred by new entrants but not by firms already in the industry. For example, product differentiation is unlikely to act as a barrier since firms already in the market must have previously incurred the costs of establishing goodwill. First-mover advantages cause entry barriers, and occur when the innovating firm retains a competitive advantage from being first in the field. E.g. ownership of patents, reputation effects (e.g. Thermos, Hoover, Coca Cola, Cutix nail polish, Kenwood, Biro, Tipex, Jablo); the first firm to enter a market may face low promotion costs because it has no rivals. 40
Neoclassical developments of SCP approach – case study: entry barriers Established firms may themselves undertake measures to raise
entry barriers – here CONDUCT impinges on STRUCTURE – by reducing the entrant’s potential to earn abnormal profits E.g. by lowering price to the LIMIT PRICE (which keeps out
entrants); the higher the entry barriers, the higher the limit price. E.g. credible threats such as building excess capacity (Spence (1977) in Entry, Capacity, Investment and Oligopolistic Pricing) Bain assumed new entrant to typically be a new small firm
building its own facilities. But what if new entrant takes over incumbent? What if new entrant is an established multi-product firm (probably already in the same industry) which decides to add an extra product to its range? What if new entrant is a foreign firm which will serve the market by exporting from their home base?
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Testing the SCP The SCP approach has generated a wide variety of empirical
work. Principal tests of SCP have sought to relate profits (or price) to: 1. 2. 3. 4.
5.
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Market concentration Market concentration plus entry barriers Differences in relative or absolute firm size causing differences in efficiency or in the rate of innovation Differential growth rates which imply that markets are in disequilibrium The level of advertising relative to sales (“advertising intensity”)
Testing the SCP Many of the tests using regression analysis show significant results. BUT there is a problem of
interpretation: a significant relationship says nothing about the direction of causation. Example: a strong positive relationship between profits and advertising intensity may be
evidence of market power, the causation running from structure to performance. Equally it could be a result of the fact that higher profits result in a larger advertising budget. Bain (1951 ) – 42 industries in 1936-40 divided into most/ less concentrated – successful
collusion between firms (concentration ratio) results in joint profit maximisation measured as return on equity (confirmed by Mann in similar study for 1950-1960) Stigler – oligopolists wish to collude in an effort to maximise profits – sample of 17
industries based on 1953-57 data – relationship between profit rates and four firm concentration ratio in excess of 80% Weiss (1971) – 23 studies – weak but positive relationship between profitability and
concentration. Brozen – in case of successful collusion in concentrated industries, above average profits
should persist over time – market is in disequilibrium
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Testing the SCP MacAvoy, McKie and Preston – only industries with
persistently high concentration levels should be studied
Demsetz (1973) – reasons other than collusion (e.g. economies of
scale, effectiveness, efficiency) CAN explain the positive relationship between profitability and concentration. Spandau – correlation between profitability and concentration in South African manufacturing industry based on profitability as measured by gross output as a measure of wages, not sales Samuels & Smyth (186 companies between 1954-63)/ Hart & Barron (1951) – negative relationship between profit rates and firm size Koch (1974) - a strong relationship between concentration and price-cost margins may even disappear when other structural variables are introduced. 44
Testing the SCP Smirlock et al. (1984) – positive relationship between profits and market
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share, between profits and growth, but no relationship between profits and concentration and between profits and entry barriers. Schmalensee (1985) – US data on 546 firms in 261 industries – industry effects explain 75% of variations in profits, while firm-specific effects are less important See Lipczynski and Wilson (2001), pgs. 172-177, and Heather (2002), pg 34, for other empirical tests The validity of the empirical tests undertaken has been questioned. Donsimoni et al. (1984) suggest that exercises seeking to relate profits to several structural variables are certain to yield some correlation. But tests that focus on particular aspects of market structure may yield results that are not robust and are difficult to interpret. Empirical studies of SCP should use cross-sectional data only if the structure of the market is stable. In practice, market stability is unlikely!
Measuring variables Testing SCP faces practical problems E.g. in studies of profitability, profit by itself is an incomplete
measure. Some firms have greater variability of earnings (measured by ß in the CAPM model: r = rf + ß[rm – rf]) and hence require higher returns to compensate. Thus if an empirical study does not account for this CAPM relationship, then if earnings variability is positively related to concentration, any positive relationship between profits and concentration may reflect this influence (i.e. earnings variability) rather than market power. 46
Measuring variables The choice of profit measure is itself a fundamental issue. Empirical studies have used: a) Accounting returns on asset (accounting Rate of Return on Assets, Accounting Rate of Return on Equity) Theoretically a firm’s entry to (or exit from) a market is in response to differences in returns on assets – so this should be the profit measure of choice. However, the treatment of depreciation might mean that accounting measures might bear little resemblance to the true economic return. Another deficiency occurs where a firm’s main source of competitive advantage comes from intangible assets (e.g. reputation, brands, customer relationships). Accounting standards prevent the real value of these assets being incorporated into company accounts (unless there is an acquisition), which can bias profitability estimates in cross-section studies and overstate the stability of profits over time. Lack of standardisation in accounting conventions which complicates direct comparisons. 47
Measuring variables b)
c)
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Price-Cost Margin, i.e. (Sales – Purchases – Salaries) / Sales excludes capital costs and advertising expenses, thus inflating margins in those industries where capital and advertising intensities are high Tobin’s q (ratio of firm stock market value to replacement value of firm assets) Rationale is that the greater a firm’s ability to earn profits on a given set of assets, the more attractive it will be to equity holders – this will raise the firm’s market value – but estimating the firm’s replacement value is not that straight-forward
Measuring variables How do you measure entry barriers? (Measures using sunk
costs have been unsuccessful; CEO survey based on Likert scale, very subjective) How do you measure entry to market? (new firms? Market penetration/ share of new entrants? Net entry? Net market penetration? )
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Markets and industries Apart from the fact that firms produce a variety of different products,
and may hence belong to more than one industry, the line of demarcation between the products belonging to one industry and those belonging to another cannot be drawn in an absolute sense. When testing the SCP approach, remember to distinguish between “markets” and “industries”: MARKETS group together firms whose products are close substitutes from
the buyers’ point of view (product demand side). Cross-elasticity of demand between products within the market is HIGH. (e.g. family cars, sport cars). Not always easy to identify clear boundaries. There is also the geographical dimension which needs to be taken account of. INDUSTRIES: product groups which are close substitutes from the suppliers’ viewpoint (product supply side). An industry is usually a broader grouping than a market. (e.g. transport vehicles) and can be seen as comprising firms which have the ability to produce, relatively rapidly, the products of any of the other firms in the group. 50
Markets and industries For purposes of analysing price and output levels of a
particular product, the market is the more relevant concept. When considering new entry into a market, this is more likely to come from firms which are in the same industry. Rather than the whole market, it may be more meaningful to undertake analysis at the level of the firm, or groups of firms with similar characteristics (e.g. strategies), i.e. a strategic group, e.g. local banks which offer personal services, local banks which focus on merchants only
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Developments of SCP approach outside Neoclassical theory Neoclassical models are STATIC – they show the equilibrium
properties of markets, but fail to show the paths by which new equilibria are reached. In reality, information is not perfect; tastes are not constant, there is uncertainty, technology cannot be taken as given => competition is a dynamic process. Clark (1940), “Towards a concept of workable competition”, argues that perfect competition model has its limitations and therefore it is dangerous to use it as a yardstick to judge markets (for policy). He argued that economic welfare would generally be enhanced by markets whose structure actually departs from the perfectly competitive point. 52
Developments of SCP approach outside Neoclassical theory Andrews (1964) in On Competition in Economic Theory,
regarded competition as a process, using term “open competition” to describe an industry open to the entry of new competition. Austrian School/ approach: Reject assumption that economic agents possess perfect
knowledge of all aspects relevant to their decisions. Knowledge is only partial. (e.g. aware of your tastes but not of available consumption possibilities) Reject the neoclassical concern with the state of equilibrium and its mathematical properties. i.e. according to the Austrians, even though the economy may be expected to move in the direction of equilibrium, the characteristics of the equilibrium are constantly changing, and the state of equilibrium is never attained. Economy is constantly in flux.
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Developments of SCP approach outside Neoclassical theory Reject the neoclassical view of competition. Major issue for Austrian
school is the competitive process, the ways in which economies evolve through time and how decisions are made in conditions of uncertainty and limited information. The actions of entrepreneurs, spurred by the pursuit of self-interest, drive the competitive process.
For the Austrian school, the essence of the competitive process is
entrepreneurial action working through the market mechanism to transfer resources to superior uses. In the neoclassical world of perfect knowledge there would be no need for entrepreneurial activity (there are no unsatisfied demand or unexploited opportunities), and no competitive process. However, statistical testing of Austrian approach is difficult. 54
Conclusive discussion SCP approach involves the logical application of neoclassical
models to draw deductions about the performance of markets Therefore the SCP is derived from a well-established body of positive economics, and deals with the objective rather than the subjective. Hence it is attractive and widely used. However, SCP is open to criticism on several counts, including excess reliance on neoclassical theory – equilibrium states and perfect information are never found in practice and are abstract conditions, hence SCP could lead to misleading analysis. But some markets MAY be sufficiently stable for the SCP approach to generate useful results. E.g. The slower the pace of technology, the more constant are people’s tastes, and the more mature the market, the more likely it is that the SCP approach will NOT be misleading. 55
Conclusive discussion Thus, for example, the SCP approach is more suitable for
analysing the car market at the end of the 20th century than at the beginning. It appears we know very little from the empirical studies of relations between structure and profitability. E.g. market concentration may be the cause of high profits or, conversely, market concentration and high profits may be the result of superior performance by a few firms. Better theory, better data and above all, better econometric analysis are needed before policy can be based on anything other than in-depth institutional studies of particular markets. An important way forward would be to develop a synthesis that recognises the unique feature of the individual firm, and links this to aspects of the market. 56
SCP Example – Food security Source: http://pdf.usaid.gov/pdf_docs/PNADL965.pdf (US Agency for International Development Famine Early Warning System) Market structure consists of the relatively stable features of the market that influence the rivalry among the buyers and sellers operating in a market. Some examples of market structure include the number of buyers and sellers of food commodities in the market, the number of sellers of agricultural inputs such as fertilizer and veterinary drugs, barriers to entry into the market and the nature of trading relations among market participants. Market conduct refers to the patterns of behaviour that traders and other market participants adopt to affect or adjust to the markets in which they sell or buy. These include price setting behaviour, and buying and selling practices. Market performance refers to the extent to which markets result in outcomes that are deemed good or preferred by society. Market performance refers to how well the market fulfills certain social and private objectives. These include price levels and price stability in the long and short term, profit levels, costs, efficiency and quantities and quality of food commodities sold.
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SCP Example – Food security (S) STRUCTURE – Number of buyers - With few buyers and sellers, they may engage in non competitive behaviours such as collusion and price discrimination. A few buyers of pastoralists’ livestock - Traders offer farmers low prices which reduces incomes of rural agricultural households. A few sellers of food commodities in the market - Retailers gain market power and increase food prices, which reduces the amount of food poor households can purchase with a given amount of income, therefore, making them relatively more food insecure than if prices were lower. A few sellers of agricultural inputs such as fertilizer and veterinary drugs -Traders overcharge farmers for agricultural inputs such as fertilizer which reduces their use of inputs and ultimately their yields and income. In the case of veterinary drugs, livestock farmers fail to buy vaccines, which could lead to animal diseases and deaths, reduced prices for livestock, lower incomes and increased food insecurity among pastoralists. A few transporters of agricultural products working between production areas and markets - Transporters charge higher prices for transporting people and food commodities which reduces farmer profits, thus reducing household income.
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SCP Example – Food security (S) STRUCTURE – Barriers to entry - This refers to factors that restrict the participation of households or traders in the market Farmers and traders lack access to credit - Farmers and traders fail to market or store commodities to sell when prices are high, thus reducing returns. When farmers store and sell later in the season, seasonal price swings become less dramatic, leading to increased income and food security of both producers and consumers. Small‐scale traders and households are deterred from starting businesses or trading, which reduces their opportunities to earn income - Traders and farmers pay high license fees before starting to trade. High license fees deter farmers from delivering output to markets by themselves, which leads to higher prices and low household income. Traders attempt to push the costs onto farmers in the form of lower producer prices and onto consumers in the form of higher consumer prices Traders pay high export and import taxes -With export taxes, the countries goods become more expensive to potential importers, and producers in the exporting country obtain less income from the sale of their surplus output. With Import taxes, traders and consumers in the importing country face higher food prices, sometimes food shortages. Traders control critical locations and assets such as stores and markets - A few traders limit the participation of other traders in the market, and make households to pay high food and input prices. 59
SCP Example – Food security (S) STRUCTURE –Vertical integration/ coordination - Farmers and livestock herders get less income depending on whether traders buy produce directly from farmers, middlemen, or transporters. Farmers sell their products in terminal, spot or auction markets - Farmers obtain efficient or competitive prices because many buyers and sellers converge in terminal, spot or auction markets. However, spot market prices tend to be volatile, therefore subjecting households to price and income risks when prices fluctuate due to changes in supply and demand for food commodities. In addition, farmers can deliver commodities to spot markets but fail to sell when there are few buyers. Farmers sell directly to buyers at their homes and/or farms - Farmers get less income, but do not incur costs of transporting produce to markets. Farmers sell through contracts to traders - Farmers obtain predictable prices and income, thus reducing food insecurity. Sometimes farmers get lower prices compared to those obtained when farmers sell on the spot market. Unlike selling on spot markets, however, if farmers deliver in contract arrangements, the quantities are specified in advance, implying that farmers have assured markets under contract sales. Farmers engage in group marketing, or are organized as cooperatives - Farmers obtain higher prices and income due to increased bargaining power, and trading in high volumes. 60
SCP Example – Food security (C) CONDUCT – Pricing Setting Behaviour - Who sets the price? How are prices determined? Traders jointly determine the price to offer producers (e.g. a few buyers of cattle secretly negotiate and agree to offer herders lower prices) - Prices offered to cattle herders are lower than those that would have prevailed in a competitive environment with many buyers. This behaviour severely reduces incomes of rural livestock herding households. Traders jointly determine the price to charge consumers (e.g. a few sellers of veterinary drugs collude and charge livestock farmers higher price) - This behaviour increases costs and reduces the use of vaccines and drugs, results in less healthy animals and higher mortality rates, poor quality livestock upon sale and consequently reduced incomes of rural pastoralists. Traders collude and pay lower prices to maize farmers - Reduces incomes of rural agricultural households, causes maize growers to cut costs by limiting employment of farm labourers and reducing the use of inputs, which ultimately can reduce output. Government sets consumer prices - If the price is set very low, consumers benefit through access to cheap food. Government sets producer prices -When prices are set above prevailing market prices, and the process is handled well, agricultural households get more income, which increases their access to other food needs. Poor agricultural households that are net consumers could actually be worse off because they have to pay more for the food they access through the market. Traders demarcate trade areas/regions and offer different farm‐gate prices to farmers in these different areas/regions for the same quality and quantity of agricultural commodities - Price discrimination makes traders underpay some farmers which results in reduced incomes. Traders charge different prices to different consumers especially if traders can differentiate between rich and poor consumers - Overcharged consumers buy less food commodities and undercharged consumers buy more food commodities for a fixed amount of money. Thus the overcharged lose and the undercharged benefit. 61
SCP Example – Food security (C) CONDUCT – Buying and selling practices Consumer prices are not transparent or openly displayed - Traders charge different prices to different consumers for the same commodity thus subjecting some households to higher costs and less food purchases. Producer prices are negotiated in private arrangements and secret bids - Traders offer different prices to farmers when buying agricultural commodities. This difference in prices leads to less income for poor households. There are no grades and standards followed when selling and buying - Traders tend to pay a lower price than the one that corresponds to the fair average quality, resulting into less income for households. Farmers do not get price premiums for producing higher grade food commodities. There are no standard units of measurements in the market for volumes traded such as weighing scales - Farmers are cheated when they go to sell in the market and thus get less income from the sale of food commodities. Farmers sell in small quantities and they do not engage in collective marketing - Farmers do not gain higher prices and income due to lack of increased bargaining power and lack of economies of scale and size from trading in high volumes.
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SCP Example – Food security (C) CONDUCT – Other conduct Consumers can return goods or services that are damaged or below standard. (i.e. goods and services are guaranteed) - High quality goods and services are more likely to be sold to farmers and consumers. Traders merge to form one large business - Traders gain market power and start overcharging consumers, thus reducing the amount of food households can buy. However, it is also argued that when traders merge, they face reduced costs and gain efficiency. Reduced costs and efficiency gains results into lower consumer prices for food commodities. Traders lobby politicians or city council officials to control markets or collection of market dues - A few traders gain too much power when they control markets. They can start to charge higher taxes from other small traders and consumers, which reduces the amount of money spent on food by other households. 63
SCP Example – Food security (P) PERFORMANCE – Price levels and stability Long run - Consumer prices for staple food crops and livestock products are higher than normal during the same period of time in previous years - Market dependant households with fixed amount of money have reduced access to food from the market. Stable and affordable prices - Households that depend on the market for food, become more food secure. Over space - The difference between consumer prices in two nearby locations differs by more than transport, marketing and transaction costs -This spatial difference can indicate that areas with high prices are more food insecure compared to those where prices of staple food crops are lower. Factors that cause this include poor infrastructure, civil unrest and climatic conditions. In the short run - Consumer prices of food crops and products change very frequently over a short period of time in some areas - This subjects poor households to uncertainty and possibly reoccurring price shocks because food becomes very expensive to buy and planning or budgeting for basic food expenditures becomes very difficult. 64
SCP Example – Food security (P) PERFORMANCE – Profits (net returns) Traders receive excessive profits or net returns from sales of food commodities - This implies that traders are overcharging food commodities, compared to costs they incur, thus reducing the amount of food that poor households can access relative to fixed incomes. PERFORMANCE – Margins and costs There are large differences between prices paid by consumers and prices received by farmers compared to marketing, processing and transaction costs for a given commodity -This indicates that produce buyers or processors are underpaying households that produce agricultural commodities and/or overcharging households that buy food commodities for consumption. These two phenomena reduce incomes of agricultural households and food access for households that depend on the market as a source of food, exposing them to food insecurity. PERFORMANCE –Volumes (quantity) There is a regular supply (volume) of staple food crops and livestock products entering the market - No shortages of food crops in the markets. This is good for food availability. Quantity of food entering the market falls below the usual average - Prices can increase, reducing the amount of food that households can access. 65
SCP Example – Food security (P) PERFORMANCE – Product quality (including nutrition) and variety The quality of food in the market is poor or below acceptable standards, which could have nutritional implications for households and particular members of households - Households are not able to consume the right amount of food with the required composition of nutrients for productive health. Food varieties are limited or different from the types that are preferred or typically consumed in some parts of a country - Households that don’t access the food they prefer or a variety of nutritious foods become food insecure. PERFORMANCE – Food Distribution within market Regular supplies to different markets in the country - Access to food to all areas including those with vulnerable populations increases food security. 66
