Another summary note on the key characteristics of market structure.

Market structure is best defined as the organisational and other characteristics of a market. We focus on those characteristics which affect the nature of competition and pricing – but it is important not to place too much emphasis simply on the market share of the existing firms in an industry.

Traditionally, the most important features of market structure are:

• The number of firms (including the scale and extent of foreign competition)
• The market share of the largest firms (measured by the concentration ratio – see below)
• The nature of costs (including the potential for firms to exploit economies of scale and also the presence of sunk costs which affects market contestability in the long term)
• The degree to which the industry is vertically integrated - vertical integration explains the process by which different stages in production and distribution of a product are under the ownership and control of a single enterprise. A good example of vertical integration is the oil industry, where the major oil companies own the rights to extract from oilfields, they run a fleet of tankers, operate refineries and have control of sales at their own filling stations.
• The extent of product differentiation (which affects cross-price elasticity of demand)
• The structure of buyers in the industry (including the possibility of monopsony power)
• The turnover of customers (sometimes known as “market churn”) – i.e. how many customers are prepared to switch their supplier over a given time period when market conditions change. The rate of customer churn is affected by the degree of consumer or brand loyalty and the influence of persuasive advertising and marketing

Summary of market structures

Characteristic	Perfect Competition	Oligopoly	Monopoly
Number of firms	Many	Few	One
Type of product	Homogenous	Differentiated	Limited
Barriers to entry	None	High	High
Supernormal short run profit	ü	ü	ü
Supernormal long run profit	û	ü	ü
Pricing	Price taker	Price maker	Price maker
Profit maximization?	ü	Not always	Usually, but not always
Non price competition	û	ü	ü
Economic efficiency	High	Low	Low
Innovative behaviour	Weak	Very Strong	Potentially strong

 

Market structure and innovation

Which market conditions are optimal for effective and sustained innovation to occur? This is a question that has vexed economists and business academics for many years.

High levels of research and development spending are frequently observed in oligopolistic markets, although this does not always translate itself into a fast pace of innovation.

The recent work of William Baumol (2002) provides support for oligopoly as market structure best suited for innovative behaviour. Innovation is perceived as being “mandatory” for businesses that need to establish a cost-advantage or a significant lead in product quality over their rivals.

Supernormal profits persist in the long-run in an oligopoly and these can be used to finance R&D

Government policy and innovation in the economy

The current government places a huge emphasis on the potential value from more innovation across all sectors of the British economy. This is because of the economic gains that follow:
For example:

• Improvements in the competitiveness of UK producers in home and overseas markets.
• Innovation helps to protect and develop comparative advantage.
• Higher productivity will keep down unit labour costs against the challenge of low-cost competition from emerging market economies.
• Innovation is a potential source of higher long-term trend growth – indeed supply creates its own demand (“Say’s Law”) and can give businesses much higher rates of return on their investment than an expansion of their existing capacity and product range.
• Innovation can also create many thousands of new jobs even though some jobs may be lost because of the adoption of labour-saving technology. The new jobs emerge in training & other services together with the demand for labour that comes from expanding output to supply an expansion to new markets.
• There might also be significant social benefits (positive externalities) from innovative behaviour – for example the delivery of new health treatments or innovations that provide safer forms of transport.

Government policy and innovation

Supply-side strategies are usually linked directly with attempts to promote more innovative behaviour. Indeed the focus of government policy is firmly focused on improvements in the microeconomics of markets. Consider this extract from a recent speech by Gordon Brown

Which policies might encourage more innovation?

• Tax credits / investment allowances
• Policies to encouragement small business creation and entrepreneurship
• Toughening up of competition policy to expose cartel behaviour, but to allow and promote joint ventures to fund research and development
• Lower corporation taxes to encourage innovative foreign companies to establish in Britain
• Increased funding for research in our universities

Important developments:

1. Increasingly most innovation is done by smaller firms – indeed multinational corporations are now out-sourcing their research and development spending to small businesses at home and overseas – much is being shifted to cheaper locations “offshore”—in India and Russia
2. Innovation is now a continuous process – in part because the length of the product cycle is getting shorter as innovations are rapidly copied by competitors, pushing down profit margins and (according to a recent article in the economist) “transforming today's consumer sensation into tomorrow's commonplace commodity” – a good example of this is the introduction of two major competitors to the anti-impotence drug Viagra
3. Innovation is not something left to chance – the most successful firms are those that pursue innovation in a systematic fashion
4. Demand innovation is becoming more important: In many markets, demand is either stable or in long-run decline. The response is to go for “demand innovation”  - discovering new forms of demand from consumers and adapting an existing product to meet them – the toy industry is a classic example of this
5. Globalisation is driving innovation and not just in manufactured goods but across a vast range of household and business services and in particular in high-value knowledge industries

Classic examples of innovation first achieved by smaller firms:

• Air-conditioning
• Hydraulic brakes
• Digital X-Rays
• Soft contact lenses
• Quick frozen food
• Zip fastener