Market Structure



Market Structure and Financial Stability

Please analyse the relationship between market structure and financial development?

The importance of financial intermediation in determining the level of real economic activity has been known for some time. Horne & Wachowicz (2000) was the first to emphasize the links between the real and financial sectors, and the crucial nature of these links was further elucidated by Horne & Wachowicz (2000). In recent years a growing body of empirical work has been devoted to establishing relationships between financial intermediation and economic development.

Greater competitiveness in product and financial markets is equivalent to a greater variety or sophistication of products and services. Variety can be thought of as one form of profit-driven innovation, an idea familiar from the endogenous growth literature. As in neo-Schumpeterian endogenous growth models, greater variety or competition in the product market directly increases aggregate production. As Boatright (2000 pp. 201-219) notes the effect is formally indistinguishable from an externality. While not critical for our main results, we also allow financial market competition to increase production possibilities. However, we posit that this occurs indirectly by lowering producers' fixed costs. This externality can be thought of in many ways. For instance, much financial innovation shows up as new services or instruments that transform firms' cost structure from sunk costs to variable costs, leasing being a notable example. Alternatively, with greater competition comes improved access to loan services, more public information and reduced search costs all of which lower the up-front costs to producers. Finally, more financial intermediaries can be thought of as reducing the aggregate probability of being denied a loan thus lowering the cost of obtaining funds.

A central concern of the present paper is how the “industrial organization” of the banking and production sectors influences real and financial development. We show that the competitiveness of intermediate goods producers has two opposing effects on intermediate goods production. On the one hand, more goods market competition produces a “market-induced demand” effect that increases the size of investment loans; on the other, more competition creates an “intermediate-goods mark-up” effect that reduces loan sizes. The two opposing effects are a primary reason for the existence of multiple steady-state equilibrium in our data. The competitiveness of financial intermediaries affects the competitiveness of intermediate goods producers mainly through production costs, which works in two conflicting ways. Market structures in both sectors are linked, because, for one, financial intermediaries exercise market power as a lender to start-ups in the intermediate goods sector. Thus, more financial market competition has a positive “financial mark-up” effect on variable costs by narrowing the spread between lending and borrowing rates. Alternatively, more competition has a negative external effect on fixed costs by reducing the setup costs of intermediate goods firms, which can be referred to as the “thick-market externality” effect. Thus, the industrial organization of banking and production sectors becomes an integral part of the dynamic interactions between financial and real activities through these four channels (Boatright, J. 2000 ...