Transcript Chapter 2

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.
Introduction
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Market structure affects market competition
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highly concentrated markets tend to be stable
unconcentrated markets tend to be more
competitive
In order to identify structure need to:
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identify competitors
define the market
Market Definition
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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 other’s ability to raise price
Market definition lies at the heart of antitrust
policy
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compute market shares to identify market power
but then need to know the size of the market
so need to define the market
Market Definition
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Simple conceptual guideline followed by antitrust 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
Market definition (cont.)
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Start with a “thought experiment”
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suppose all firms in the supposed market could
coordinate their prices
would they choose to raise prices by at least
5%?
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if yes then there are few “outside” competitors
If ŋx is “small” then sellers
the market is well defined
face few constraints on
theirdemand
ability to raise prices.
Related to own-price elasticity of
ŋx = -
% change in quantity demanded of x
% change in price of x
Market definition (cont.)
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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
Identifying Competitors
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Any one who produces a substitute for a firm’s
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
Direct and Indirect Competitors
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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
Characteristics of Substitutes
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Two products tend to be close substitutes
when these 3 criteria are jointly satisfied:
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They have similar performance characteristics
They have similar occasion for use and
They are sold in the same geographic area
Performance Characteristics
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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
Occasion for Use
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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
Competitor identification (cont.)
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The 3 qualitative criteria can be supplemented
by quantitative data
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direct estimates of cross-price elasticities
price correlation
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prices of substitute products tend to move together over time
allocated to the same Industrial Classification code
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but at what level?
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pharmaceuticals are in SIC code 2834
but not all drugs are substitutes
and competitors can be allocated to different SIC codes
Geographic Area
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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
Geographic Competitor
Identification
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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
Competitors in the Area
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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
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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
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A common measure of concentration is the Nfirm concentration ratio - combined market
share of the largest N firms
CR4 = Si Si
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where Si is firm’s 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)
Four Classes of Market Structure
Structure
Perfect
Competition
Monopolistic
Competition
Oligopoly
Monopoly
Herfindahl Index
Usually < 0.2
Intensity of Price Competition
Fierce
Usually < 0.2
Depends on the degree of
product differentiation
Depends on inter-firm rivalry
Light unless there is threat of
entry
0.2 to 0.6
> 0.6
Market Structure and Competition
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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
Perfect Competition
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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
Zero Profit Condition
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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
Conditions for Fierce Price
Competition
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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
Many Sellers
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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
Homogenous Products
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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
Excess Capacity
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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
Monopoly
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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 monopolist’s profits
Monopoly and Output
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A monopolist sets the price so that marginal
revenue equals marginal cost
Thus the monopolist’s 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
Monopoly and Innovation
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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
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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 monopolist’s profits are restricted
Monopolistic Competition
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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
Vertical and Horizontal Differentiation
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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
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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
Spatial Differentiation
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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
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“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
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An important determinant of a firm’s demand
is customer switching
Switching is less likely when
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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
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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
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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
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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 economic profit
Existence of economic profits will attract new
entrants until each firm’s economic profit is
zero
Theory of Monopolistic Competition
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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
Oligopoly
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
Evidence on Concentration and
Price
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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
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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
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The concentration and profitability have not
been shown to have a strong relationship
Possible explanations
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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