Quiz 14: Market Structures Iv: Contestable Markets

Theory of firms: According to Ronald Coase, the firm's organizing activity is more efficient than market exchange. That is, if the individual wants to produce a car, then they need to get the spare parts from more than 2,000 suppliers, which lead to huge transaction cost. If the firm produces the car, then they will buy bulk amount of spare parts from different suppliers. This, in turn, reduces the transaction cost and time.Reason for multiple firms: Firms buying inputs from other firms for the following reasons: • Cost advantage : The cost of production would reduce if the firm employs specialization. Hence, the assembling firm can buy the spares from other firms that are specialized in producing that input at a lesser price than producing it on their own. • Reduce the capability of manager : When the firm concentrates on more than one product, then the managerial ability of coordination and communication declines, which causes diseconomies of scale.• Quality maintenance : When the firm concentrates on single goods production, then it can produce that good with the best quality due to specialization. • Multiple suppliers : A firm requires more number of spares to produce a complete product. Hence, it is not possible for a single firm to produce, since it involves more complications. Also, more number of suppliers are available in the market to supply those inputs at a lesser price.

Vertical integration: Vertical integration refers to the expansion of a firm into different stages of production so as to have control over their suppliers to reduce cost and improve efficiency. Example: The car manufacturing firm buys the inputs such as spare parts from different suppliers. After a certain period, the firm will buy some of the supplier firm's spare parts or it will start to produce some of the inputs on its own. Determinants of vertical integration: The vertical integration of the firm is determined by the following factors: • Ability of manager: The manager's ability to administrate the firm decreases as the number of firms increases. Hence, the vertical integration depends on the manager's ability to administrate the number of firms. • Cost of inputs: If the cost of inputs is higher than it produces itself, then it benefits the firm to adopt vertical integration. • Suppliers: If there is no sufficient number of suppliers in the market, then the firm should adopt vertical integration to avoid the shortage of inputs. • Quality: If the supplier can produce the inputs with high quality, then the firm should buy it from the supplier and vice-versa.

Crude oil: Drilling and refining managed by two different firms: Company A buys crude oil from another firm and refines it instead of drilling crude oil on their own for the following reasons: • The manager may not be able to administrate the refinery and crude oil production. • The number of staffs may not be sufficient enough to manage the drilling and refining of crude oil on their own. • The cost of drilling crude oil on their own may be higher for company A than its crude oil suppliers. • The quality of company A's crude oil may be inferior to the crude oil supplied by its suppliers. Crude oil: Drilling and refining managed by a single firm: Company T can drill crude oil and refine it on its own for the following reasons: • It may have sufficient number of staffs to manage crude oil production and oil refinery. • The manager of company T can administrate both the units with efficiency and cost effectiveness. • Company T can produce better quality crude oil at low cost than buying input (crude oil) from other firms (suppliers).

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