Economics of Strategy

1
Economics of Strategy
Besanko, Dranove, Shanley and Schaefer, 3rd
Edition
Chapter 6 Competitors and Competition
Slide show prepared by Richard
PonArul California State University, Chico
? John Wiley ? Sons, Inc.
2
Introduction

• Market structure affects market competition
• highly concentrated markets tend to be stable
• unconcentrated markets tend to be more
  competitive
• In order to identify structure need to
• identify competitors
• define the market

3
Market Definition

• A market is that set of suppliers and demanders
  whose trading establishes the price of a good.
• Firms are in the same market if they constrain
  each others ability to raise price
• Market definition lies at the heart of antitrust
  policy
• compute market shares to identify market power
• but then need to know the size of the market
• so need to define the market

4
Market Definition

• Simple conceptual guideline followed by
  anti-trust authorities merger with all the
  competitors should lead to a small but
  significant nontransitory increase in price
  (SNIP criterion)
• Small, but significant 5 for US DoJ
• 5 to 10 for EU
• In practice, two firms can be said to compete if
  a price increase by one firm drives its customers
  to the other firm

5
Market definition (cont.)

• Start with a thought experiment
• suppose all firms in the supposed market could
  coordinate their prices
• would they choose to raise prices by at least 5?
• if yes then there are few outside competitors
• the market is well defined
• Related to own-price elasticity of demand

If ?x is small then sellers face few
constraints on their ability to raise prices.
change in quantity demanded of x
?x -
change in price of x
6
Market definition (cont.)

• This approach relies on group elasticity
• individual product elasticity might be high
• RAS o Generali o Toro
• but group elasticity would be low
• if all three increase prices together they will
  lose little custom

7
Identifying Competitors

• Any one who produces a substitute for a firms
  product is its competitor
• How good a substitute is one product for another
  is measured by the cross price elasticity of
  demand
• A firm may have competitors in several input
  markets and output markets at the same time

8
Direct and Indirect Competitors

• Direct competitors Strategic choice of one firm
  directly affects the performance of the other
• Indirect competitors Strategic choice of one
  firm affects the performance of the other because
  of a strategic reaction by a third firm

9
Characteristics of Substitutes

• Two products tend to be close substitutes when
  these 3 criteria are jointly satisfied
• They have similar performance characteristics
• They have similar occasion for use and
• They are sold in the same geographic area

10
Performance Characteristics

• Listing of performance characteristics is a
  subjective but useful exercise
• Products that belong to the same genre or fall
  under the same SIC need not be substitutes
  (Example Mercedes and Hyundai) if their
  performance characteristics are vastly different

11
Occasion for Use

• Products may share characteristics but may differ
  in the way they are used
• Orange juice and cola are beverages but used in
  different occasions
• Another example could be hiking shoes versus
  court shoes

12
Competitor identification (cont.)

• The 3 qualitative criteria can be supplemented
  by quantitative data
• direct estimates of cross-price elasticities
• price correlation
• prices of substitute products tend to move
  together over time
• allocated to the same Industrial Classification
  code
• but at what level?
• pharmaceuticals are in SIC code 2834
• but not all drugs are substitutes
• and competitors can be allocated to different SIC
  codes

13
Geographic Area

• Identical products in two different geographic
  markets will not be substitutes due to
  transportation costs
• Bulky products like cement cannot be transported
  over long distances to benefit from geographic
  price difference

14
Geographic Competitor Identification

• When a firm sells in different geographical
  areas, it is important to be able identify the
  competitor in each area
• Rather than rely on geographical demarcations,
  the firm should look at the flow of goods and
  services across geographic regions

15
Two Step Approach to Identifying Competitors in
the Area

• First step is to find out where the customers
  come from (the catchment area)
• The second step is to find out where the
  customers from the catchment area shop
• With the technological innovations, some products
  like books and drugs are sold over the internet
  bringing in virtual competitors

16
Market Structure

• Markets are often described by the degree of
  concentration
• Monopoly is one extreme with the highest
  concentration - one seller
• Perfect competition is the other extreme with
  innumerable sellers

17
Measuring Market Structure

• A common measure of concentration is the N-firm
  concentration ratio - combined market share of
  the largest N firms
• CR4 Si Si where Si is firms
  i market share and
• i 1, 4
• Herfindahl index is another which measures
  concentration as the sum of squared market shares
• H Si Si2 where
• i 1,.n (n is total number of firms in the
  market)

18
Four Classes of Market Structure
19
Market Structure and Competition

• A monopoly market may produce the same outcomes
  as a competitive market (threat of entry)
• A market with as few as two firms can lead to
  fierce competition
• With monopolistic competition, how well
  differentiated the products are will determine
  the intensity of price competition

20
Perfect Competition

• Many sellers who sell a homogenous product and
  many well informed buyers
• Consumers can costlessly shop around and sellers
  can enter and exit costlessly
• Each firm faces infinitely elastic demand

21
Zero Profit Condition

• With perfect competition economic profits go to
  zero
• Percentage contribution margin PCM equals (P -
  MC)/P where P and MC are price and marginal cost
  respectively
• When profits are maximized PCM 1/? where ? is
  the elasticity of demand
• Since ? is infinity, PCM 0

22
Conditions for Fierce Price Competition

• Even if the ideal conditions are not present,
  price competition can be fierce when two or more
  of the following conditions are met
• There are many sellers
• Customers perceive the product to be homogenous
• There is excess capacity

23
Many Sellers

• With many sellers, cartels and collusive
  agreements harder to create
• Cartels fail since some players will be tempted
  to cheat since small cheaters may go undetected
• Even if the industry PCM is high, a low cost
  producer may prefer to set a low price

24
Homogenous Products

• For firms that cut prices, customers switching
  from a competitor are likely to be the largest
  source of revenue gain
• Customers are more likely to price shop when the
  product is perceived to be homogenous and hence
  sellers are more likely to compete on price

25
Excess Capacity

• When a firm is operating below full capacity it
  can price below average cost as price covers the
  variable cost
• If industry has excess capacity, prices fall
  below average cost and some firms may choose to
  exit
• If exit is not an option (capacity is industry
  specific) excess capacity and losses will persist
  for a while

26
Monopoly

• A monopolist faces little or no competition in
  the product market
• Monopolist can act in an unconstrained way in
  setting prices
• If some fringe firms exist, their decisions do
  not materially affect the monopolists profits

27
Monopoly and Output

• A monopolist sets the price so that marginal
  revenue equals marginal cost
• Thus the monopolists price is above the marginal
  cost and its output below the competitive level
• The traditional anti-trust view is that limited
  output and higher prices hurt the consumer

28
Monopoly and Innovation

• A monopolist often succeeds in becoming one by
  either producing more efficiently than others in
  the industry or meeting the consumers needs
  better than others
• Hence, consumers may be net beneficiaries in
  situations where a firm succeeds in becoming a
  monopolist

29
Monopoly and Innovation

• Monopolists are more likely to be innovative
  (than firms facing perfect competition) since
  they can capture some of the benefits of
  successful innovation
• Since consumers also benefit from these
  innovations, they are hurt in the long run if the
  monopolists profits are restricted

30
Monopolistic Competition

• There are many sellers and they believe that
  their actions will not materially affect their
  competitors
• Each seller sells a differentiated product
• Unlike under perfect competition, in monopolistic
  competition each firms demand curve is downward
  sloping rather than flat

31
Vertical and Horizontal Differentiation

• Vertically differentiated products unambiguously
  differ in quality
• Horizontally differentiated products vary in
  certain product characteristics to appeal to
  different consumer groups
• An important source of horizontal differentiation
  is geographical location

32
Spatial Differentiation

• Video rental outlets (or grocery stores) attract
  clientele based on their location
• Consumers choose the store based on
  transportation costs
• Transportation costs prevent switching for small
  differences in price

33
Spatial Differentiation

• The idea of spatial location and transportation
  costs can be generalized for any attribute
• Consumer preferences will be analogous to
  consumers physical location and the product
  characteristic will be analogous to store location

34
Spatial Differentiation

• Transportation costs will be the the cost of
  the mismatch between the consumers tastes and
  the products attributes
• Products are not perfect substitutes for each
  other
• Some products are better substitutes (low
  transportation costs) than others

35
Theory of Monopolistic Competition

• An important determinant of a firms demand is
  customer switching
• Switching is less likely when
• Customer preferences are idiosyncratic
• Customers are not well informed about alternative
  sources of supply
• Customers face high transportation costs

36
Theory of Monopolistic Competition
37
Theory of Monopolistic Competition

• The demand curve DD is for the case when all
  sellers change their prices in tandem and
  customers do not switch between sellers
• The demand curve dd is for the case when one
  seller changes the price in isolation and
  customers switch sellers
• Sellers pricing strategy will depend on the
  slope of dd

38
Theory of Monopolistic Competition

• If dd is relatively steep, sellers have no
  incentive to undercut their competitors since
  customers cannot be drawn away from them
• If dd is relatively flat (stores are close to
  each other, products are not well differentiated)
  sellers lower prices to attract customers and end
  up with low contribution margins

39
Monopolistic Competition and Entry

• Since each firms demand curve is downward
  sloping, the price will be set above marginal
  cost
• If price exceeds average cost, the firm will earn
  economic profit
• Existence of economic profits will attract new
  entrants until each firms economic profit is zero

40
Theory of Monopolistic Competition

• Even if entry does not lower prices (highly
  differentiated products), new entrants will take
  away market share from the incumbents
• The drop in revenue caused by entry will reduce
  the economic profit
• If there is price competition (products that are
  not well differentiated) the erosion of economic
  profit will be quicker

41
Oligopoly

• Market has a small number of sellers
• Pricing and output decisions by each firm affects
  the price and output in the industry
• Oligopoly models (Cournot, Bertrand) focus on how
  firms react to each others moves

42
Cournot Duopoly

• In the Cournot model each of the two firms pick
  the quantities Q1 and Q2 to be produced
• Each firm takes the other firms output as given
  and chooses the output that maximizes its profits
• The price that emerges clears the market (demand
  supply)

43
Cournot Reaction Functions
44
Cournot Equilibrium

• If the two firms are identical to begin with,
  their outputs will be equal
• Each firm expects its rival to choose the Cournot
  equilibrium output
• If one of the firms is off the equilibrium, both
  firms will have to adjust their outputs
• Equilibrium is the point where adjustments will
  not be needed

45
Cournot Equilibrium

• The output in Cournot equilibrium will be less
  than the output under perfect competition but
  greater than under joint profit maximizing
  collusion
• As the number of firms increases, the output will
  drift towards perfect competition and prices and
  profits per firm will decline

46
Bertrand Duopoly

• In the Bertrand model, each firm selects its
  price and stands ready to sell whatever quantity
  is demanded at that price
• Each firm takes the price set by its rival as a
  given and sets its own price to maximize its
  profits
• In equilibrium, each firm correctly predicts its
  rivals price decision

47
Bertrand Reaction Functions
48
Bertrand Equilibrium

• If the two firms are identical to begin with,
  they will be setting the same price as each other
• The price will equal marginal cost (same as
  perfect competition) since otherwise each firm
  will have the incentive to undercut the other

49
Cournot and Bertrand Compared

• If the firms can adjust the output quickly,
  Bertrand type competition will ensue
• If the output cannot be increased quickly
  (capacity decision is made ahead of actual
  production) Cournot competition is the result
• In Bertrand competition two firms are sufficient
  to produce the same outcome as infinite number of
  firms

50
Bertrand Competition with Differentiation

• When the products of the rival firms are
  differentiated, the demand curves are different
  for each firm and so are the reaction functions
• The equilibrium prices are different for each
  firm and they exceed the respective marginal costs

51
Bertrand Competition with Differentiation

• When products are differentiated, price cutting
  is not as effective a way to stealing business
• At some point (prices still above marginal
  costs), reduced contribution margin from price
  cuts will not be offset by increased volume by
  customers switching

52
Price-Cost Margins and Concentration

• Theory would predict that price-cost margins will
  be higher in industries with greater
  concentration (fewer sellers)
• There could be other reasons for inter-industry
  variation in price-cost margins (regulation,
  accounting practices, concentration of buyers and
  so on)

53
Price-Cost Margins and Concentration

• It is important to control for these extraneous
  factors if one need to study the relation between
  concentration and price-cost margin
• Most studies focus on specific industries and
  compare geographically distinct markets

54
Evidence on Concentration and Price

• For several industries, prices are found to be
  higher in markets with fewer sellers
• In markets where the top three gasoline retailers
  had sixty percent share prices were 5 percent
  higher compared to markets where the top three
  had a fifty percent share
• For service providers such as doctors and
  physicians, three sellers were enough to create
  intense price competition

55
Economies of Scale and Concentration

• Industries with large minimum efficient scales
  compared to the size of the market tend to have
  high concentration
• The inter-industry pattern of concentration is
  replicated across countries
• When production/marketing enjoys economies of
  scale, entry is difficult and hence profits are
  high

56
Concentration and Profitability

• The concentration and profitability have not been
  shown to have a strong relationship
• Possible explanations
• Differences in accounting practices may hide the
  differences in profitability
• When the number of sellers is small it may be due
  to inherently unprofitable nature of the business