Thursday, March 21, 2013

Are there supply curves in a theory of return-seeking firms

In the theory of return-seeking firms there is no supply curve as such.  There are simply reactions by firms given their expectations about 1) the persistence of a demand shock, 2) their competitiveness.

Under normal conditions where demand increases in line with expectations, mark-up pricing that is set at a level to discourage competitor entry, can continue to be used.  However, there are many pricing options available to a firm to win market share (a discussion for a later post). 

The below model shows the case of three firms in a market.  The rate of return earned at the starting position is proportional to the market power/competitiveness of the industry.  The theory has nothing to say about whether three firms will result in reduced competition.  Competition, or lack thereof, is an artifact of local monopolies, regulatory frameworks, capital barriers and so forth. In a market with free entry and local competition, three firms can easily be very competitive. 

A shift in the demand curve in this model need not have any special impacts on prices under any period of analysis.  There are no assumptions about the slope of a supply curve.  What exists is an ability to interpret price changes as evidence of market/monopoly power.  For example, if demand for oil tankers increased over a short period, ship builders would have years to increase their mark-ups and returns before a competitor could become established.  However, they may choose not to take all the possible increase in returns to decrease the attractiveness for a new competitor, or to win market share from an existing competitor - no use making high return now, but being forced to accept very low returns in the future when new firms enter the market.  

The price setting during a short term demand shock is not at all the result of costs faced by firms, but of market power. 

To recap, an unexpected sudden shift in demand can provide temporary monopoly power for firms currently in the market (since the shift is beyond the planned capital investments in the market). In markets where new capital takes many years of investment, or there are regulatory barriers to investment, higher prices would be expected.  However in markets where production is highly competitive between established firms vying for market share,  sudden shifts in market demand may lead to falling prices. 

The below interactive graph the demand shock slider shifts the demand curve.  The market power slider sets the starting market power and shows that higher mark-ups / returns will be acheived with greater market power. The checkbox allows market power to be related to demand shocks to demonstrate the case that even in apparently competitive markets unexpected demand shocks might themselves create temporary market power. 

1 comment: