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Contents
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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
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.
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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
Porter (Competitive Strategy, 1980) used it as an analytic tool for businesses striving to compete within a market including on the fact that it is based too exclusively upon neoclassical theory.
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?
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
B.
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
characteristics of individual markets within the economy. Here structure describes the environment within which firms in a particular market operate.
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 Porters 5 forces model
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Porters 5 Forces
POTENTIAL ENTRANTS
SUPPLIERS
BUYERS
SUBSTITUTES
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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
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Performance
The economists 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?
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.
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theoretical measure of market power. See Lerner, A. P. (1934), "The Concept of Monopoly and the Measurement of Monopoly Power
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
current/ past performance, hence yielding few insights into how well firms will perform in satisfying customer wants over time.
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Structure
Conduct
Performance
then turns on matching the structural characteristics against the models of perfect competition, monopoly, monopolistic competition, and oligopoly.
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Monopolistic competition Profit maximisation No advertising Oligopoly Possible profit maximisation Advertising and other non-price competition Possible profit maximisation Some advertising
Monopoly
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Allocatively inefficient
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?
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in the market; E.g. innovation and advertising may raise entry barriers; E.g. predatory pricing could force competitors out of the markets.
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.
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linkages, although the essential causality still flows from structural criteria.
Structure
Conduct
Performance
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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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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.
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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.
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.
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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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"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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(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.
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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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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.
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some predictive way, SCPs 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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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)
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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.
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entry barriers here CONDUCT impinges on STRUCTURE by reducing the entrants 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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work. Principal tests of SCP have sought to relate profits (or price) to:
1. 2. 3. 4.
5.
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)
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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
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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.
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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!
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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 in the CAPM model: r = rf + [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.
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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 firms 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 firms 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.
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Measuring variables
b)
c)
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 Tobins q (ratio of firm stock market value to replacement value of firm assets) Rationale is that the greater a firms ability to earn profits on a given set of assets, the more attractive it will be to equity holders this will raise the firms market value but estimating the firms replacement value is not that straight-forward
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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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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.
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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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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.
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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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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.
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.
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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 peoples tastes, and the more mature the market, the more likely it is that the SCP approach will NOT be misleading.
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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.
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