Concentration and Prices

Concentration is an important factor affecting pricing and profitability within markets.

Other things being equal, increases in concentration can be expected to be associated with increased prices and profits.

One way to make this point is to appeal to the extreme cases of pure competition and pure monopoly. Under pure competition, market price equals average cost, leaving all firms zero economic profits (i.e., normal rates of return). Low concentration leads to minimum prices and zero profits. Under a pure monopoly, in contrast, a single dominant firm earns maximum excess profit by optimally raising the market price. Given these polar results, it is natural to hypothesize a positive relationship between an industry’s degree of monopoly (as measured by concentration) and industry prices. For instance, the smaller the number of firms that dominate a market (the tighter the oligopoly), the greater is the likelihood that firms will avoid cutthroat competition and succeed in maintaining high prices. High prices may be a result of tacit collusion among a small number of equally matched firms. But even without any form of collusion, fewer competitors can lead to higher prices. The models of price leadership and quantity competition (analyzed in the next section) make exactly this point.

There is considerable evidence that increases in concentration promote higher prices. The customary approach in this research is to focus on particular markets and collect data on price (the dependent variable) and costs, demand conditions, and concentration (the explanatory variables). Price is viewed in the functional form

P f(C, D, SC),

where C denotes a measure of cost, D a measure of demand, and SC seller concentration. Based on these data, regression techniques are used to estimate this price relationship in the form of an equation. Of particular interest is the separate influence of concentration on price, other things (costs and demand) being equal. The positive association between concentration and price has been confirmed for a wide variety of products, services, and markets—fromretail grocery chains to air travel on intercity routes; from cement production to television advertising; from auctions of oil leases and timber rights to interest rates offered by commercial banks. More generally, a large-scale study of manufacturing (using five-digit product categories) for the 1960s and 1970s shows that concentration has an important effect on

prices for consumer goods and materials (and a smaller positive effect for capital and producer goods).4

Is an increase in monopoly power necessarily harmful to the interests of consumers? The foregoing discussion citing the evidence of higher prices would say yes. However, an alternative point of view claims that monopoly (i.e., large firms) offers significant efficiency advantages vis-á-vis small firms.5 According to this hypothesis, monopoly reflects superior efficiency in product development, production, distribution, and marketing. A few firms grow large and become dominant because they are efficient. If these cost advantages are large enough, consumers can obtain lower prices from a market dominated by a small number of large firms than from a competitive market of small firms. Thus, a price comparison between a tight oligopoly and a competitive market depends on which is the greater effect: the oligopoly’s cost reductions or its price increases. For example, suppose that in the competitive market Pc ACc, and, in the tight oligopoly Po 1.15ACo. Absent a cost advantage, the oligopoly exhibits higher prices. But if the oligopoly’s average cost advantage exceeds 15 percent, it will have the lower overall price.

The evidence concerning monopoly efficiency is mixed at best. It is hard to detect significant efficiency gains using either statistical approaches or case studies. Large firms and market leaders do not appear to be more efficient or to enjoy larger economies of scale than smaller rivals. (They do profit from higher sales and prices afforded by brand-name allegiance.) Nonetheless, the efficiency issue offers an important reminder that greater concentration per se need not be detrimental. Indeed, the government’s antitrust guidelines mentioned earlier cover many factors—concentration, ease of entry, extent of ongoing price competition, and possible efficiency gains—in evaluating a particular industry.

Fares on air routes around the world offer a textbook case of the link between concentration and prices. Numerous research studies have shown that average fares on point-to-point air routes around the globe vary inversely with the number of carriers. Indeed, the degree of competition on a particular route is a much stronger predictor of airfares than the distance actually traveled.

The effect of competition can be seen in several ways. Airline deregulation in the United States began in 1978. Fares were deregulated, and air routes were opened to all would-be carriers. In the first decade of deregulation, the average number of carriers per route increased from 1.5 to almost 2. During the same period, deregulated fares proved to be about 20 percent

4See C. Kelton and L. Weiss, “Change in Concentration, Change in Cost, Change in Demand, and Change in Price,” in Leonard Weiss (Ed.), Concentration and Price. (Cambridge, MA: MIT Press, 1989). This book provides a comprehensive collection and critical analysis of the price-concentration research. 5This view often is referred to as the University of Chicago-UCLA approach, because much of the research originated at these schools. For discussion and critique, see M. Salinger, “The Concentration-Margins Relationship Reconsidered,” Brookings Papers: Microeconomics (1990): 287–335.

Business Behavior: Global Airfares

below what they would have been absent deregulation.6 Since 1988, average airfares have continued to decline (after adjusting for general inflation and higher fuel costs).

However, in recent years, the advent of the “hub system” and the industry consolidation via mergers have meant reduced competition on many routes. American Airlines accounts for about 70 percent of all flights to and from Dallas-Fort Worth. Delta Airlines controls over 75 percent of the traffic in Atlanta, Cincinnati, Detroit, Minneapolis, and Salt Lake City. Together, United Airlines and American Airlines account for some 85 percent of all flights at Chicago’s O’Hare Airport. United and Southwest Airlines provide nearly 60 percent of the flights in Denver. Fares at hub airports dominated by a single airline tend to be more than 20 percent higher than those in comparable routes. Conversely, on routes where discount airlines have entered and compete successfully with incumbent carriers, fares have dropped by 30 to 50 percent. Nonetheless, discount carriers complain of barriers to entry (few or no takeoff and landing slots) and the predatory practices (incumbents’ sudden price cuts and flight increases) that keep them from competing on key routes.

Air route competition in Europe and the rest of the world is far behind developments in the United States. European governments have a long history of protecting national carriers from competition by foreign airlines. The result is far fewer competing carriers on the major European air routes and, therefore, elevated fares. Because of protectionist policies, an intranational fare (Paris to Marseilles) may be much higher than an intra-European fare (Paris to Athens), which, in turn, is higher than an international fare (Paris to New York). Indeed, protection from competition has led to inefficiency and high operating costs (especially among the state-owned airlines). Because of high wages and low labor productivity, operating costs at European airlines are more than 40 percent above those of U.S. airlines. In short, high concentration within Europe coincides with high costs (not economies of scale). Despite elevated prices, most European airlines have struggled to break even. Only recently have discount carriers like Ryanair and EasyJet begun to penetrate important European markets, spurring incumbent carriers to cut unnecessary costs and to reduce fares.

QUANTITY COMPETITION

There is no single ideal model of competition within oligopoly. This is hardly surprising in view of the different numbers of competitors (from two upward) and dimensions of competition (price, product attributes, capacity, technological

6See S. Morrison and C. Winston, “Airline Deregulation and Public Policy,” Science, August 18, 1989, pp. 707–711.