1.
What are the implications of the relationship between MES (the minimum efficient scale of
production) and the level of market demand for the degree of seller concentration in an
industry?
Answer:
The minimum efficient scale (MES) is defined as the lowest scale necessary for it to achieve
the economies of scale required to operate efficiently and competitively in its industry. No
further significant economies of scale can be achieved beyond this scale. MES points at the
output level beyond which the firm can make no further savings in LRAC (long-run average cost)
through further expansion. In other words, the MES is achieved when all economies of scale are
exhausted. MES corresponds to the lowest point on the LRAC curve and is also known as an
output range over which a business achieves production efficiency. Textbook microeconomic
theory suggests a U-shaped long-run average cost function as MES is not a single output level: as
soon as economies of scale are reached; for any range of output levels over which the LRAC
function is flat, the firm experiences constant returns to scale. Afterwards, the firm immediately
experiences diseconomies of scale. In short, MES seeks to identify the point at which a firm can
produce its goods cheaply enough to offer them a competitive price in the marketplace (Figure
1).
For companies that produce goods, it is critical to find an optimal balance between consumer
demand, production volume, and the costs associated with manufacturing and delivering
goods. A range of production costs go into establish a minimum efficient scale, but its
relationship to the size of its market (the demand for the product) determines how many
competitors can effectively operate in the market.
As said in last paragraph, minimum efficient scale affects the number of firms that can operate in
a market, and the structure of markets. When minimum efficient scale is low, relative to the size
of the whole industry, many firms can operate efficiently, as in the case of most retail
businesses, like corner shops and restaurants. However, if minimum efficient scale can only be
achieved at very high levels of output relative to the whole industry, the number of firms in the
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industry will be small and concentrated. This is the case with natural monopolies, such as water,
gas, and electricity supply.
The relationship between the minimum efficient scale and industry size gives information as to
the optimal level of concentration that yields efficient production. If the minimum efficient scale
is large. Economies of scale result from savings in the long-run average cost (LRAC) achieved as a
firm operates at a larger scale. The output level at which the firm’s LRAC attains its minimum
value is the firm’s minimum efficient scale (MES) of production. The comparison between the
total output that would be produced if each incumbent firm operates at its MES, and the total
demand for the industry’s product at the price required for at least normal profit to be earned,
has important implications for the number of firms that the industry can accommodate. This in
turn has implications for seller concentration and industry structure. If the total demand for the
product equals the MES, the most cost-efficient arrangement is for the industry to be serviced by
a single firm, and industry structure is most likely to be monopolistic. If the total demand for the
product is 1,000 times as large as the MES, then the industry can accommodate 1,000 firms all
producing at the MES, and the industry structure might approximate perfect competition.
However, if average costs are approximately constant over a range of output levels beyond the
MES, the actual number of firms might be less than the number that could be accommodated if
all were operating at (but not beyond) the MES (LIPCZYNSKI, WILSON and GODDARD, 2017, pp.
287-288).
2. Why is it often necessary to police cartel agreements? Who polices OPEC?
Answer:
A cartel is a group of firms that acts collectively, often in order to increase their joint profitability
by exploiting their (collective) market power. Additionally, a cartel agreement is a formal
agreement between two or more companies/countries that agree on certain ideas. As par
Liefmann (1932), the cartel will typically agree to coordinate pricing and marketing standards
with the intention of gaining a monopoly status. The cartel is a type of collusive oligopoly, a form
of market, in which few independent firms in the same industry form a mutual agreement to
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avoid competition. Cartels are often associated with actions taken by small groups of firms
determined to exploit their market power to the full; alternatively, firms join cartels mainly for
reasons of self-defense or protection (Hunter, 1954). Agreements tend, overall, to impede entry
or the development of new products that might threaten the profitability or survival of
incumbent firms. For a group of oligopolists, collusion may represent a way of dealing with the
uncertainties that would otherwise arise due to their situation of interdependence. Collusion
may be simply a means of easing competitive pressure and creating a manageable operating
environment through unified action, rather than necessarily a strategy for maximizing joint
profits (LIPCZYNSKI, WILSON and GODDARD, 2017, p. 196). However, to assume that all collusion
is organized through the medium of cartels is an oversimplification. Meanwhile, price-fixing
seems only to be of secondary importance after fixing output quotas, usually to support the less
efficient members (Fog, 1956; Asch and Seneca, 1976). Nevertheless, evidence suggests that
overcharges arising from cartel agreements are substantial (Connor, 2014; Boyer and Kotchoni,
2015).
Wilcox (1960) identifies four main categories of cartel according to the methods employed:
cartels that control the conditions surrounding a sale; cartels that control costs, prices and profit
margins; cartels that allocate territories or customers; and cartels that award members fixed
shares in the industry’s total productive capacity. Many cartels fall under more than one of these
headings.
Why policing required
Though cartel agreement has some benefits in the economy, the demerits are non-negligible as
well. In order to minimize the negative effects of cartelling, it requires policing (monitoring and
controlling) both internally and externally. The internal policing should be conducted by the
cartel organization itself whereas, the domestic and international competition law, protection
law, monetary policy etc. would act as external polices.
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Internal
1. D’Aspremont et al. (1983) show that a cartel that is both internally and externally stable can
always be achieved if the number of firms is finite. A corollary is that the greater the number of
firms in the industry, the smaller the effect of any one firm’s actions on price and profits, and the
greater the likelihood that any cartel agreement will turn out to be unstable. Therefore, the
cartel policy makers should limit the number of cartel firms.
2. Any decision by a cartel firm to break the cartel agreement has a non-negligible effect on
the profits of both the cartel firms that remain loyal and the non-cartel firms. In this case, the
cartel authority must take an action to force complying the agreement. In a study of restrictive
practices in the food trade, Cuthbert and Black (1959) document the use of fines and expulsion
as direct sanctions for firms in breach of a cartel agreement. Fines were sometimes heavy, while
expulsion implies the loss of any advantage from cartel membership.
In the model shown in Figure 2, a decision by one cartel firm to withdraw from the cartel and
produce q2 rather than q1 would shift the non-cartel supply function to the right and the cartel
residual demand and marginal revenue functions to the left. This would reduce the equilibrium
price and reduce the profits of both the cartel and the non-cartel firms. Before any defection
takes place, the profit of a non-cartel firm always exceeds the profit of a cartel firm. However,
this does not rule out the possibility that the post-defection profit of the cartel firm that defects
is less than its predefection profit when it was still part of the cartel.
3. Individual firms may not be able to detect fellow conspirators’ price cuts. In Williamson’s
terminology, information is impacted, giving rise to opportunistic behavior. Monitoring is
necessary to detect and deter noncompliance with the cartel agreement. Monitoring and
policing an agreement are more complex in cases where there are non-price forms of
competition.
External
1. We know that, one manifestation of cartel agreement/collusion is price-fixing. An example
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of the power a cartel has on increasing prices is the International Coffee Agreement between
1965 and 1989. Igami (2015) estimated that prices of coffee beans were 75 per cent above a
Cournot-competitive level and there was a $12 billion transfer from consumers to producer
countries. The ‘coffee crisis’ of the early 1990s was 80 per cent due to the collapse of the cartel
agreement. Price-fixing is easily recognized as having adverse consequences for consumer
welfare (LIPCZYNSKI, WILSON and GODDARD, 2017, p. 196). This incident clearly depicts why
external authorities like government, UN should police cartels.
2. Cartels have a negative effect on consumers because their existence results in higher prices
and restricted supply. The Organization for Economic Cooperation and Development (OECD) has
made the detection and prosecution of cartels one of its priority policy objectives.
Who polices OPEC
The Organization of Petroleum Exporting Countries (OPEC) is the world's largest cartel. It is a
grouping of 14 oil-producing countries whose mission is to coordinate and unify the petroleum
policies of its member countries and ensure the stabilization of oil markets. Even though, OPEC is
considered by most to be a cartel, members of OPEC have maintained it is not a cartel at all but
rather an international organization with a legal, permanent and necessary mission (Chen, 2019).
Internal
The OPEC Conference is the supreme authority of the organization, and consists of delegations
normally headed by the oil ministers of member countries. The chief executive of the
organization is the OPEC Secretary General.
External
1. The United States (US): US is one of the largest producers, exporters and reservoirs of
petroleum resources (like, oil) but keeps itself physically away from OPEC. However, it has been
believed that, US has the most influence over OPEC in international arena. For example, OPEC’s
activities are legal because U.S. foreign trade laws protect it though many organizations like EU
oppose the idea of OPEC cartel. Interestingly, the advent of new technology,
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especially fracking in the United States, has had a major effect on worldwide oil prices and has
lessened OPEC’s influence on the markets. Moreover, Petrodollar gives the US a significance
authority over OPEC.
2. Saudi Arabia: This country is the most powerful one within OPEC and serves as the de facto
leader. Saudi Arabia’s Minister of Petroleum & Natural Resources has the most authoritative
voice within OPEC. The minister controls the taps to around 12.5m barrels per day (bpd) of
capacity, which makes Saudi the world’s most influential supplier. Good political, financial and
military relationship with USA helps Saudi to exercise its power within OPEC (excluding Qatar is
an example).
3. Explain to what extent the theory of limit pricing provides a useful contribution to the theory
of entry deterrence?
Answer:
Limit pricing is a pricing strategy by an incumbent firm intended to prevent entry. The incumbent
sacrifices some profit by setting a price sufficiently low to make it impossible for an entrant to
operate profitably. The limit price is defined as the highest price the incumbent believes it can
charge without inviting entry. The limit price is below the monopoly price, but above the
incumbent’s average cost.
Entry-deterring strategies are barriers to entry that are created or raised deliberately by
incumbents through their own actions. Relevant actions might include changes in price or
production levels, or in some cases merely the threat that such changes will be implemented if
entry takes place. A credible threat of this kind may be sufficient to deter potential entrants from
proceeding. The extent to which it is possible for an incumbent to adopt entry-deterring
strategies depend on the degree of market power exercised by the incumbent (Cabral, 2008).
Limit pricing can be used as a tool to deter new entrants based either on: an absolute cost
advantage or an economy of scale. A critical assumption underlying models of limit pricing
concerns the nature of the reaction the entrants expect from the incumbent, if the entrants
proceed with their entry decision. A key assumption of these models is that entrants assume the
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incumbent would maintain its output at the pre-entry level if entry takes place. Therefore, the
incumbent is prepared to allow price to fall to a level determined by the location of the
combined post-entry output. This is also identified as zero conjectural variation.
Figure 3 shows the limit pricing model in the case of an absolute cost advantage entry barrier. It
is assumed there is a single incumbent and a fringe comprising many small competitive potential
entrants. LRAC1 is the incumbent’s average cost function, and LRAC2 is the entrants’ average
cost function. In order to concentrate solely on the effects of absolute cost advantage (and
exclude economies of scale), it is assumed both LRAC functions are horizontal, and therefore
equivalent to the long-run marginal cost (LRMC) functions. The incumbent’s monopoly price and
output are (PM, QM). At all output levels, the entrants’ average cost is below PM. Therefore, if
the incumbent operates at (PM, QM) initially, entry takes place subsequently. The entrants
produce Q* - QM, reducing the price to P*, and reducing the incumbent’s abnormal
profit from BPMEG (pre-entry) to BP*FG (post-entry).
Suppose instead the incumbent pursues a limit-pricing strategy in the short run. This involves
operating at (P*, Q*) initially. If entry takes place, industry output is increased above Q*, causing
price to fall below P*(= LRAC2). The entrants’ residual demand function shows the relationship
between industry price and the entrants’ output, assuming (in accordance with the zero
conjectural variation assumption) the incumbent maintains its output at Q*. The residual
demand function is equivalent to the segment of the market demand function that lies to the
right of Q*. Since the residual demand function lies below LRAC2 at all output levels, the
entrants conclude they cannot earn a normal profit and abstain from entry. The incumbent’s
position at (P*, Q*), and its abnormal profit of BP*HJ, are sustainable in both the pre-entry and
post-entry periods. BP*HJ exceeds BP*FG, the long-run abnormal profit in the previous case
where the incumbent starts at (PM, QM) and allows entry to take place.
Figure 4 shows the limit pricing model in the case of an economies of scale entry barrier. In this
case, it is more natural to consider the case of a single incumbent and a single entrant (rather
than a fringe of small competitive entrants), because both firms would need to operate at a
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reasonably large scale in order to benefit from economies of scale. For simplicity, only the limit
pricing solution (and not the comparison with the monopoly pricing solution) is shown. LRAC is
the average cost function of both the incumbent and the entrant. The incumbent can prevent
entry by operating at (P*, Q*). As before, the residual demand function is the entrant’s effective
demand function when the incumbent is producing Q*, equivalent to the section of the market
demand function to the right of Q*. The residual demand function lies below LRAC at all output
levels. If the entrant produces a low output, it fails to benefit from economies of scale. If the
entrant produces a high output, it benefits from economies of scale, but the extra output causes
price to drop to a level that is unprofitable. Therefore, the entrant concludes it cannot earn a
normal profit at any output level and abstains from entry (LIPCZYNSKI, WILSON and GODDARD,
2017, pp. 337-339).
4. Discuss whether limit pricing is preferable to monopoly pricing on social welfare criteria.
Answer:
Social Welfare: In economics, social welfare is the sum of consumer surplus and producer surplus
(LIPCZYNSKI, WILSON and GODDARD, 2017, p. 783). For instance, the market price for a
commodity is 8 kr. The customer is willing to pay 10 kr. for the good, whereas the seller is ready
to sell it for 5 kr. In such case, the consumer surplus is (10-8) = 2 kr. and the producer surplus is
(8-5) = 3 kr. Hence, the value of social welfare for the particular commodity is (2+3) = 5 kr.
As par the Parisian criterion, given certain rules of distribution, any economic reorganization is
said to increase social welfare, if the welfare of some persons is increased without any decrease
in the welfare of others. In terms of indifference curve analysis, an optimum position is one in
which it is not possible to put any person on a higher indifference curve without causing
someone to drop to a lower one. Moreover, Adam Smith implicitly accepted the growth of the
wealth of a society, that is, the growth of the gross national product, as a welfare criterion. He
believed that economic growth resulted in the increase of social welfare because growth
increased employment and the goods available for consumption to the community (Economics
Discussion, 2019).
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Limit pricing: A pricing strategy by an incumbent firm intended to prevent entry. The incumbent
sacrifices some profit by setting a price sufficiently low to make it impossible for an entrant to
operate profitably. The limit price is defined as the highest price the incumbent believes it can
charge without inviting entry. The limit price is below the monopoly price, but above the
incumbent’s average cost (LIPCZYNSKI, WILSON and GODDARD, 2017, p. 337).
Monopoly pricing: Monopoly pricing is a pricing strategy followed by a seller, whereby the seller
prices a product to maximize his or her profits under the assumption that he or she does not
need to worry about competition. In other words, monopoly pricing assumes the absence of
competitors being able to garner a larger market share by charging lower prices.
Monopoly pricing requires not only that the seller have significant market power, possibly a
monopoly or near-monopoly or a cartel of oligopolists, but also that the barriers to entry for
selling that good are high enough to dissuade potential competition from being attracted by the
high pricing. In particular, monopoly pricing is infeasible in perfect competition markets
(Market.subwiki.org, 2019).
In case of limit pricing, limit pricing is a policy that followed by the monopoly market. Limit pricing
causes reduced profit margins, protects their industry and thus the firms are inefficient because
of lack of competition, worse off for the consumers in the aspect that there will be no Dynamic
efficiency, worse off for other firms trying to enter the market, worse off for Government because
of a less saturated, competitive, efficient and growing market as well as a decrease in tax revenues.
According to Figure 3, explained properly in the previous question, there is a residual demand
(the market demand that is not met by other firms in the industry at a given price). It denotes
that, though there is a demand in the market, the existing firm deters fulfilling it by restricting
other firms coming into play. Eventually, it restricts the GNP, and is an obstacle to social welfare.
Furthermore, there is limited empirical evidence concerning the use or effectiveness of limit
pricing strategies. Much of the evidence that is available is anecdotal.
The monopolist typically fails to produce at the minimum efficient scale, and therefore fails to
produce at the lowest attainable average cost. The monopolist earns an abnormal profit in the
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long run, while the perfectly competitive firm earns only a normal profit. Under monopoly, there
is allocative inefficiency because price exceeds marginal cost. Industry output is too low, and
welfare could be increased by producing more output. Under monopoly, there may also be
productive inefficiency, if a lack of competitive pressure implies a monopolist becomes
complacent or lazy, failing to achieve full technical or economic efficiency. Monopoly produces a
deadweight loss (the loss of social welfare), and the sum of consumer surplus and producer surplus
is lower than it is under perfect competition.
The idea that competition is always preferable to monopoly has not gone unchallenged. If the
monopolist can operate on a lower average or marginal cost function than the firms comprising
a perfectly competitive industry, then social welfare could be higher under monopoly than under
perfect competition. The theories of natural monopoly and price discrimination can also be used
to make a case for monopoly based on social welfare criteria (LIPCZYNSKI, WILSON and
GODDARD, 2017, p. 710). For example, a pharmaceutical company invents a vaccine for AIDS
which is very expensive in reality. The company enjoys the monopoly and charges a very high
price in developed countries. In contrary, the company keeps the vaccine price at minimal in
under-developed countries. By using such price discrimination, the company actually increase
social welfare which is supported by Parisian criteria. Overall, the theoretical evidence as to
whether monopolies lead to a reduction in efficiency and social welfare is inconclusive.
Though the economists do not prefer either limit pricing or monopoly pricing, for the sake of
better social welfare, I would choose monopoly pricing operating on a lower average or marginal
cost.
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APPENDICES
Figure 1:
Figure 2:
Figure 3:
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Figure 4:
REFERENCES
1. Cabral, L.M.B. (2008) Barriers to entry, in Durlauf, S.N. and Blume, L.E. (eds) The New Palgrave
Dictionary of Economics, 2nd edn. London: Palgrave Macmillan.
2. Chen, J. (2019). Organization of the Petroleum Exporting Countries (OPEC). [online] Investopedia.
Available at: https://www.investopedia.com/terms/o/opec.asp [Accessed 23 Nov. 2019].
3. Economics Discussion. (2019). Social Welfare (6 Major Criteria). [online] Available at:
http://www.economicsdiscussion.net/economics-2/social-welfare-6-major-criteria/6034 [Accessed 24
Nov. 2019].
4. Lipczynski, J., Wilson, J. and Goddard, J. (2017). Industrial Organization: Competition, Strategy and
Policy. 5th ed. Harlow, UK: Pearson Education Limited, p.196.
5. Lipczynski, J., Wilson, J. and Goddard, J. (2017). Industrial Organization: Competition, Strategy and
Policy. 5th ed. Harlow, UK: Pearson Education Limited, pp.287-288.
6. Lipczynski, J., Wilson, J. and Goddard, J. (2017). Industrial Organization: Competition, Strategy and
Policy. 5th ed. Harlow, UK: Pearson Education Limited, pp.337-339.
7. Lipczynski, J., Wilson, J. and Goddard, J. (2017). Industrial Organization: Competition, Strategy and
Policy. 5th ed. Harlow, UK: Pearson Education Limited, p.710,783.
8. Market.subwiki.org. (2019). Monopoly pricing - Market. [online] Available at:
https://market.subwiki.org/wiki/Monopoly_pricing [Accessed 24 Nov. 2019].
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