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Markets that are perfect are like fish that can fly (2/3)

In this article, part 2 of our three-part series*, Investors’ Corner presents the thinking on market mechanisms and imperfections of Nobel laureate Professor Jean Tirole, who is a keynote speaker at the BNP Paribas Asset Management 2019 Investment Forum on the theme of disruptive change in a superstar economy.

Markets that are perfect are like fish that can fly – these are not their main characteristics[1]

Market mechanisms, theorised at the end of the 19th century (see our article Introduction to the works of Jean Tirole), are commonly used in finance: Fixing of the opening and closing prices, continuous quotes on the equity and foreign exchange markets.[2] The financial markets are centralised, the products traded are perfectly homogenous, buyers and sellers are sufficiently numerous and anonymous and can change roles (a buyer will sell next time for profit taking or stop loss or change in his expectations). The price at which the transactions take place is unique and determined by the market mechanism.

Commodity markets have different characteristics, not least because participants are only on one side of the market, either sellers or buyers. The market brings together producers and consumers, as does a market for goods and services. However, there is also perfect competition in the commodity markets because the products are homogenous.

Markets are not just financial, far from it

In the markets for goods and services, perfect competition is not an operational concept because of the variety of products requested by the consumer, the asymmetry of information and lack of coordination. This reality is best reflected in monopolistic competition with, to the extreme, monopoly giving market power[3] to a single company. When there are few companies, they can interact, which characterises an oligopoly.

The markets for goods and services, in their functioning, can therefore be described as imperfect[4] compared to the assumptions of perfect competition. Regulations can be put in place to correct the excesses of these ‘imperfections’ and/or to transform the structure of an industry (for example, to open up a monopoly to competition). Changing the starting point will improve the balance and thus social well-being.

To regulate, one must first identify the main characteristics of the economy.

Perfect competition to the test of reality

In perfect competition, the only relevant information is the equilibrium price (p*). In particular, a company (‘supplier’ in the summary table below) does not have to know the behaviour of its competitors and clients. There is only one product per market. This situation would correspond to the assumption of a command and centralised economy in which the consumer cannot choose the product to be consumed. It is easy to show that the equilibrium price is equal to the marginal cost and that, in the general equilibrium, the price is at the minimum average cost. As a result, economic profit, calculated as the difference between revenue and costs (which include, among other things, wages and returns on capital), is zero.

Summary table: Market imperfections

Summary table: Market imperfections

In the other situations presented in the table above, the company is a ‘price maker.’

Monopolistic competition occurs when there are many sellers (as in perfect competition), each firm sets its price (as in a monopoly situation), and the products are differentiated, but substitutable. They have substantially the same function for the consumer without being homogenous. The decision to buy will depend on consumer preferences and sales conditions.

For a good or a service, the differentiation for the consumer (the variety on offer) is mainly due to the characteristics of the product, and in particular its quality (upmarket product; different functionalities or services). The variety of products is common to monopolistic competition, monopoly and oligopoly and explains why the company must have information about consumer demand to set a price. In particular, this knowledge makes it possible to establish how the consumer will react to a change in price or quality. Here we see the concept of price elasticity, which is important in microeconomics as well as macroeconomics. It has the particularity of not resulting from theoretical calculations, but from empirical verifications. The company's strategy relies largely on knowing its customers' price elasticity for each type of product or service.

Monopoly and oligopoly

Monopolistic competition is halfway between perfect competition and monopoly. It is important to understand the functioning of a monopoly (or oligopoly, which is a variant) to better grasp the ins and outs of regulation.

A monopoly is the situation where only one company sells a product and sets the price that maximises its profit. According to economic theory, it is an equilibrium for the company, but not necessarily an optimum for the economy as a whole.[5] However, there are many reasons for the existence of a monopoly beyond the predatory behaviour of companies seeking to capture the entire market by absorbing or eliminating their competitors.

A company that has a decreasing average cost of production due to high fixed costs (the need to build a transmission or distribution network – telecommunications, water, gas, electricity) will be in a natural monopoly. The division of production between two companies would not be optimal as their average cost would be higher than that of the monopoly. The state can also choose to institutionalise a monopoly (concessions). It then negotiates a price that is more favourable to the consumer, but must also take into account the company's costs. The exploitation of a natural resource or a patent often results in a monopoly situation, which is generally limited over time. Technological innovations may temporarily create a monopoly between when they are implemented and when other innovations replace them. Let us not forget that innovations are found in the production function, and thus in production costs (e.g. robotisation), but also in products, and thus in demand (e.g. laptops). This is a major factor in long-term economic growth. It is Joseph Schumpeter's concept of ‘creative destruction.’

In the context of the rapid technological changes that marked the beginning of the 21th century, we encounter this situation more frequently: We are not revolutionising automobile production every day with Fordism, but we can imagine innovations in products and services more quickly thanks to the advances of certain technologies.

Economic theory teaches that, in a monopoly situation, the quantity produced is lower and the sales price higher than in perfect competition. However, a monopoly is not free from the consumer demand function when setting the sales price that will drive its margin rate. If demand varies little according to price, the market power of the monopolistic enterprise will be high. It can also decide to offer products of different quality and prices to capture as much as possible of the consumer's surplus.

In an oligopoly, companies must interact

In practice, oligopolies can be found in sectors such as car manufacturing or the tobacco industry, but also, for example, in the brewing industry, where a few large players have acquired their smaller competitors in recent years. Cooperation between companies within an oligopoly leads to the creation of a cartel or local monopolies (‘dividing up the world’ between two French airline companies decades ago; water distribution).

In most cases, an oligopoly is non-cooperative, and each company will make its decisions (on price or quantity) based on what it assumes is the behaviour of the other members of the oligopoly. In economic terms, it is a question of making assumptions about the reaction function of competitors. This comes on top of knowledge of the consumer demand function that we have highlighted for monopolistic competition and monopoly.

A new approach to the company

One of the important contributions of Jean Tirole's work has been the formalisation of interactions in an oligopoly through game theory. Previously, for an economist, a company was, in fact, a black box which turns various observed inputs into a final product and realised a profit). As a result, the scope of systematic studies was limited: It is possible to see a correlation between, for example, the concentration rate of an industry and the profits made by companies in the sector without capturing the causal effects at work. The conclusions that could be drawn from such studies were often rudimentary (avoiding cartels, breaking down monopolies) and without any real prospective dimension, which reduced their effectiveness.

By allowing, always through models, rigorous study of strategic interactions, the economist can provide more relevant advice (to the company on its organisation or to the state on regulation) that will be adapted to a specific industry. This approach makes it possible to take account of information asymmetries and to understand how a change in regulation can correct them. Industrial organisation theory has moved from static behavioural observation (this industry is in this situation) to a cognitive approach to the company (competitor relationships, research and development policy, product differentiation). Understanding strategic choices (past and future) makes it possible to better specify the particular characteristics of the sector and thus make regulation more effective (opening the sector up to competition, dominant firm regulations).

In our third article, we will illustrate, with a few practical cases, the benefits of this approach, which the speed of technological innovation makes even more relevant.

[1] Loosely based on a quote from The President (a film by Henri Verneuil, screenplay by Michel Audiard, 1961)

[2] Until 1992, the exchange rate fixings on the Paris stock exchange were like a Walras’ ‘trial and error’ procedure. Léon Walras drew inspiration from the perpetual annuity quotations in the 1870s. The currency market is ‘centralised’ by means of continuous arbitrages between currencies and between different markets.

[3] The firm has market power when it decides to set a price above its marginal cost. In perfect competition, a company that chooses a price higher than the equilibrium price loses all its customers as the substitution elasticity is infinite.

[4] In particular, they are imperfect as mechanisms for coordinating supply and demand. Invisible transaction costs (‘search costs’) are no longer zero as in a perfect market.

[5] The monopoly price, which is higher than the marginal cost, reduces the consumer's surplus and social well-being via the deadweight loss.

*Also read: Jean Tirole – Introduction to the works of the prize-winning economist (Part 1) / Jean Tirole – Why and how to regulate? (Part 3)  / Does a rise in market power explain the ills of developed economies? /  Superstar firms and the concentration of corporate power – getting out of hand?

For more articles by Nathalie Benatia, click here >

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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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