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Economics of Strategy
Market Structure and Dynamic
Competition
Defining Markets
• “that set of suppliers and demanders whose
trading practices establishes the price of a good”
– George Stigler and Robert Sherwin
Close substitutes
• same or similar product performance
characteristics
• same or similar occasions for use
• same geographic market
Product performance characteristics
• subjective analysis of “similar” products
• to reduce subjectivity, list the attributes which you
believe are most influential in the consumers
purchase decision
Occasions for use
• Where is the product used?
• When is the product used?
• How is the product used?
Geographic Market
• Is the product sold by competitors where
customers
– are not affected by transportation costs
• costs of time for the consumer to travel to an alternative
location to purchase
• costs of shipping the product to the customers location
– are not affected by tax differences
– convenience is not a major factor
When is the product used?
How is the product used?
• To listen to music…
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Radio
CD Player
Tape Player
Eight…. No don’t go there
Computer Files?
Problems
• identifying precise product performance
characteristics is subjective and imprecise
• does not answer “how good a substitute is it?”
– Use elasticity to solve this
• transportation costs can be influential
• convenience can be influential but the price
customers are willing to pay for it is subjective
Defining the Market
• Market definition is the identification of the
market(s) in which the firm is a player
• Two firms are in the same market if they constrain
each other’s ability to raise the price
• It is important to define the market if market
shares need to be computed (for anti-trust
economics or business strategy formulation)
Well-Defined Market
• If the market is well defined, firms outside the
candidate market will not be able to constrain the
pricing behavior of those inside
• A thought experiment: If all the firms inside the
candidate market colluded, can they raise the price
by at least 5%? If they can, the market is well
defined
Coca Cola’s Market
• Is Coca Cola’s market, the market for cola drinks
or the market for all potable liquids (including tap
water)?
• In the face of anti-trust concerns, Coke would
have preferred the broader definition
• Judicial system found the carbonated drinks
market to be the relevant one
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
Two Step Approach to Identifying
Geographic Competitors
• 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
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
Measuring Market Structure
• A common measure of concentration is the N-firm
concentration ratio - combined market share of the
largest N firms
• Herfindahl index is another which measures
concentration as the sum of squared market shares
• Entropy could be another measure of
concentration
– How fast do competitors disappear and appear?
Hirfindahl Index
Structure
Perfect Competition
Monopolistic
Competition
Oligopoly
Monopoly
Herfindahl Index
Usually < 0.2
Usually < 0.2
0.2 to 0.6
> 0.6
Intensity of Price Competition
Fierce
Depends on the degree of product
differentiation
Depends on inter-firm rivalry
Light unless there is threat of entry
Market Structures
• Chart
Market Structure and Dynamic
Competitive Forces
• 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
• Schumpeter’s “gale of creative destruction”
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
• PRICE TAKERS
Zero Profit Condition
• With perfect Competition economic profits are
driven to zero
• Percentage contribution margin or per unit profits
– PCM = (P - MC)/P
• where P is price and MC is marginal
• When profits are maximized PCM = 1/ where 
is the elasticity of demand
• Since  is infinity, PCM = 0
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
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There are many sellers
Customers perceive the product to be homogenous
There is excess capacity
Competitive
Contestable Markets exist
Many Sellers
• With many sellers, cartels and collusive
agreements difficult to create/maintain
• 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
Homogenous Products
• Make for better substitutes!
– 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
• Customers switching from a competitor is likely to
be the largest source of revenue gain
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 can persist
Contestable Markets
• the viable threat of competition from interloper
firms is enough to keep firms acting as if it had
actual competitors.
• Critical role of entry to dissipate profits
• Low barriers to entry required
Monopoly
• A monopolist faces little or no competition in the
product market
• Monopolist can act in an unconstrained way in
setting prices
• A monopolist profit maximizes
– equilibrate marginal revenue and marginal costs
– price on the demand curve
• PRICE SEARCHERS
Monopoly and Output
• A monopolist perpetually understocks the market
and charges too high a price - Adam Smith
• Price exceeds the competitive price
• Price exceeds the marginal costs of production
• Output is below the competitive level
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
Monopoly and Innovation
• Monopolists are more likely to be innovative
(relative to firms facing perfect competition)
because they can capture some of the benefits of
successful innovation
• Since consumers also benefit from these
innovations, they can be hurt in the long run if the
monopolist’s profits are restricted
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 firm’s demand curve is
downward sloping rather than flat
• Usually very elastic demand for the firm - many
close substitutes
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
Spatial Differentiation
• Video rental outlets (or grocery stores) attract
clientele based on their location
• Consumers choose the store based on their
“transportation costs”
• Transportation or transactions costs prevent
switching for small differences in price
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
Spatial Differentiation
• “Transportation costs” will be the the cost of the
mismatch between the consumers’ tastes and the
product’s attributes
• Products are not perfect substitutes for each other
• Some products are better substitutes (low
“transportation costs”) than others
Theory of Monopolistic Competition
• An important determinant of a firm’s
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
Theory of Monopolistic Competition
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
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
Monopolistic Competition and Entry
• Since each firm’s demand curve is downward
sloping, the price will be set above marginal cost
• If price exceeds average cost, the firm will earn
short run economic profit
• But ease of entry with short run economic profits
will attract new entrants until each firm economic
profit is zero
• Long run economic profit is zero
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 (where products that
are not well differentiated) the market mimics pure
competition and the erosion of economic profit
will be quicker
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 other’s moves
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 firm’s output as given
and chooses the output that maximizes its profits
• The price that emerges clears the market (demand
= supply)
Cournot Reaction Functions
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
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
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
Bertrand Reaction Functions
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
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
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
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
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 interindustry variation in price-cost margins
(regulation, accounting practices,
concentration of buyers and so on)
Price-Cost Margins and
Concentration
• It is important to control for these
extraneous factors if one need to study the
relation between concentration and pricecost margin
• Most studies focus on specific industries
and compare geographically distinct
markets
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
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
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