Transcript PowerPoint

Competitors and Competition
Besanko, Dranove, Shanley, and
Schaefer
Chapters 6
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Agenda
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Competitor Identification
Measuring Market Structure
Market Structure and Competition
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Perfect Competition
Monopoly
Monopolistic Competition
Oligopoly
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Competitor Identification
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One way of identifying competitors is to
examine the cross-price elasticity of
demand.
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yx = (∂Qy/Qy) / (∂Px/Px)
yx = (Qy/Qy) / (Px/Px)
If this is positive, then the goods are
considered substitutes.
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Direct vs. Indirect Competitor
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A direct competitor is one whose
strategic choices directly affect the
other company.
An indirect competitor is one who
affects your company through the
strategic choices of a third company.
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Conditions For Being Close
Substitutes
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Competing products have the same or
similar product performance
characteristics.
Competing products have the same or
similar occasions for use.
Competing products are sold in the
same geographic market.
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Differing Geographic Market
Conditions
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Products are said to be in different
geographic markets if they are:
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Sold in different locations.
Costly for either the producer or consumer
to transport the goods.
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Market Definition
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It identifies the market(s) in which the
firm compete(s).
Two firms are said to exist in the same
market if they constrain each other’s
ability to raise price.
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Measuring Market Structure
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Market structure is the number and
distribution of companies in a market.
The concentration level of the
companies in your market can have a
direct effect on your pricing strategy.
Two measures:
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N-Firm Concentration Ratio
The Herfindahl Index
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N-Firm Concentration Ratio
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The N-Firm Concentration Ratio gives
the combined market share of the N
largest firms.
A problem with this measure is that it
does not take into consideration the
proportions of each of the N largest
companies.
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Hence a shift of market share from one
large firm to another goes unnoticed.
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The Herfindahl Index
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The Herfindahl Index (HFI) is defined as the
summation of the squared market shares of
all firms in the market.
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HFI = i (Si)2 = S12 + S22 + … + SN2
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Where Si is the market share for firm i.
This index will account for changes in market
share between companies.
The reciprocal of the HFI is known as the
numbers-equivalent of firms, which in essence
tells you how many firms the market appears to
have.
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Market Structure and
Competition
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Market competition is usually broken up
into the following four general areas:
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Perfect Competition
Monopoly
Monopolistic Competition
Oligopoly
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Market Structure and
Herfindahl Index
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Perfect and Monopolistic Competition
tend to be seen in industries with a HFI
index less than 0.2.
Oligopolies usually have a HFI between
0.2 and 0.6.
Monopolies tend to have HFI equal to
0.6.
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Perfect Competition
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Perfect Competition is said to exist if the
following conditions hold:
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Homogeneous products
No barriers to entry or exit
Large number of buyers and sellers
Perfect information
No collusion between the sellers or buyers
No externalities (Perloff, Microeconomics)
Transaction costs are low (Perloff,
Microeconomics)
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Homogeneous Product
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A homogeneous product is a good that
has a perfect substitute, i.e., it does not
matter who produced the good because
the good appears to be the same no
matter who produced it.
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E.g., #2 Yellow Corn, clothes pin
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No Barriers to Entry or Exit
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No barriers to entry or exit implies that
anyone can enter or exit the market
without substantial cost.
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Farming can be perceived as having an
ever increasing barrier to entry which is
the high cost to acquire the land.
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Large Number of Sellers
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The key to this condition for
competition is that no particular seller
has the ability to affect the market
because of her decisions.
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Perfect Information
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There must exist for all participants
information regarding prices, quantities,
qualities, etc.
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With the internet and the idea of precision
farming, all the sectors in the economy are
moving closer to this condition.
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No Collusion
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Collusion occurs when people get
together as a group and make decisions
that affect the market.
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E.g., OPEC, stores that run ads regarding
price matching
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No Externalities
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An externality “occurs when a person’s
well-being or a firm’s production
capability is directly affected by the
actions of other consumers or firms
rather than indirectly through changes
in prices.” (Perloff, Microeconomics)
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E.g., Odor from a farm, pesticide drift
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Low Transaction Costs
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“Transaction costs are the expenses of
finding a trading partner and making a
trade for a good or service other than
the price paid for that good or service.”
(Perloff, Microeconomics)
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E.g., having two sellers a great distance
apart.
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Competitive Firms
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Competitive firms tend to operate
where price is equal to marginal cost
implying that there PCM is at zero.
They are always in fierce pricing
competition with other firms in their
market.
Competitive firms are usually not able
to set prices, they take prices as given.
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Monopoly
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A monopoly exists if there is little competition
in its output market or input market.
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Monopolist relates to output markets.
Monopsonist relates to input markets.
A monopoly does not have to be the only firm
in a market.
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The key is that other firms cannot sufficiently
affect it through there actions.
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Monopoly Cont.
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Monopolies have the ability to affect
price through there output decisions.
Being a monopoly does not necessarily
mean that you can charge monopoly
prices.
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It depends on the level of potential
competition.
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Monopoly Cont.
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Monopolies also have varying levels of
price discriminatory power.
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If the monopoly cannot distinguish
between buyers, it must use the market
demand curve to set one price.
A perfectly discriminatory monopoly would
charge each buyer there marginal gain for
each output level.
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A Monopoly Problem
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Suppose a monopoly existed in the emu
industry.
Currently the firm that sells emu has a
variable cost of $10 for each emu and is
facing a demand curve for their product of
P(Q) = 100 – 2*Q.
What is the optimal amount of emus to
produce and what is the optimal price.
Assume there are no fixed costs.
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Monopoly Solution
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The goal is to maximize profits ().
 = Total Revenue – Total Cost
 = P(Q)*Q – VC*Q
 = (100-2Q)*Q – 10*Q
 = (100*Q-2Q2) – 10*Q
∂/∂Q = 90 - 4Q = 0
This implies optimal output occurs at 22.5
and optimal price equals 55.
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Monopolistic Competition
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Monopolistic competition is
characterized by having most of the
same conditions as perfect competition,
where the only difference is that the
products are viewed by the consumer to
have slightly different characteristics,
i.e., the products are differentiated.
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Differentiation in Monopolistic
Competition
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Vertical Differentiation
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When a product has characteristics that
make it unambiguously better or worse
than a competing product.
Horizontal Differentiation
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When a product has characteristics that
some consumers prefer over a competing
product.
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Differentiation in Monopolistic
Competition Cont.
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Even if two products are homogenous,
they still could be differentiated by
geographic location.
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Geographic Differentiation
Example
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Suppose you have two sellers of ice
cream where their products have the
same physical characteristics.
Seller A is located at the north end of
town, and seller B is located at the
south end of time.
Suppose these two sellers are 10 miles
apart.
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Geographic Differentiation
Example Cont.
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Assume that there are three customer
bases in the city.
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Customer base 1 is located 4 miles from
seller A and 5 miles from seller B.
Customer base 2 is located 5 miles from
seller A and 5 miles from seller B.
Customer base 3 is located 6 miles from
seller A and 4 miles from seller B.
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Geographic Differentiation
Example Cont.
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If it costs $1 per mile to travel, which
store would each consumer base go to?
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What would happen if seller B lowered his
price by $0.50?
What would you need to know to know if
seller B is better off?
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Oligopoly
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Oligopoly markets are characterized by a few
large producers controlling most of the
market.
The action of just one company can have an
effect on the industry price.
There are generally two types of competition
considered with oligopolies:
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Cournot Quantity Competition
Bertrand Price Competition
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Cournot Quantity Competition
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In this type of competition, each firm
chooses how much output it will
produce.
After quantity has been chosen, they
consider what price to charge to clear
the market.
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Cournot Quantity Competition
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Cournot competition is characterized by
each firm developing a best response to
what it thinks its rival will do.
It does this by developing a reaction
function.
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A reaction function is a response function
to what you believe your competitor is
going to do.
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Cournot Equilibrium
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A Cournot Equilibrium is the outputs and
market price that satisfy the following two
conditions:
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The equilibrium price is the price that clears the
market given the firms’ production levels.
The equilibrium quantity of each firm is the best
response to the equilibrium quantity chosen by the
other firms.
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Best response means that there is no better choice given
your competitors strategy.
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Cournot Equilibrium Example
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Suppose there are only two firms in the
market using the same technology and has
the same costs.
Suppose the market demand is the following:
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P = 100 – Q
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Where Q is the total quantity in the market.
Also assume that the cost for each unit
produced by each firm is $10 per unit of
output.
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Cournot Equilibrium Example
Cont.
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What is the Cournot Equilibrium price
and quantity for each firm?
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Answer will be worked out in class.
Note: Cournot Competition does not
maximize industry profits.
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Bertrand Price Competition
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Unlike the Cournot Model, the Bertrand
price model has the firm choosing price
rather than quantity.
Due to this price competition, price is
pushed down to marginal cost.
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The key to obtaining this solution is that
the products are perfect substitutes.
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Bertrand Versus Cournot
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The Cournot model considers a two stage
decision process where output is first chosen
and then price is considered, while the
Bertrand model assumes that price is set and
each firm then sets quantity.
The Bertrand model is related more to
industries that have flexible production
capacity.
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