Economics of Strategy

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 • 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

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 other’s 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

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

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 ŋx is “small” then sellers face few constraints on their ability to raise prices. % change in quantity demanded of x ŋx = - % change in price of x

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

Identifying Competitors • 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 • 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 • 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

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

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

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

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

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 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

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 CR4 = Si Si 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 Si2where i = 1,…….n (n is total number of firms in the market)

Four Classes of Market Structure

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

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

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

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

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

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

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

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 monopolist’s profits

Monopoly and Output • 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 • 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 (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 • 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 • 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 “transportation costs” • Transportation 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 economic profit • Existence of economic profits will attract new entrants until each firm’s 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 (products that are not well differentiated) 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

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 Cournot Equilibrium

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 Duopoly

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

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 Cournot and Bertrand Compared

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

Economics of Strategy