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Competitive Industry Analysis

Competitive Industry Analysis. Competitors and Competition. Outline for this week. Mkt definition and competitors Criteria Concentration, Herfindhal Index Cross elasticity Competitive Pricing issues Perfect / oligopolistic competition Monopoly Oligopoly Cournot equilibrium

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Competitive Industry Analysis

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  1. Competitive Industry Analysis Competitors and Competition

  2. Outline for this week • Mkt definition and competitors • Criteria • Concentration, Herfindhal Index • Cross elasticity • Competitive Pricing issues • Perfect / oligopolistic competition • Monopoly • Oligopoly • Cournot equilibrium • Bertrand equilibrium

  3. Competitor Definition • Who is Coke competing against? • Does it include Dr. Pepper, 7-Up, bottled water?< • Is Bombardier competing against Airbus, Boeing, Embraer, or Bell Helicopter? • Who is Air Canada competing against? • Does it include Inotech-Execair, Porter, Sun Wing, Transat, Air France, Westjet? • Who is Labatt competing against? • Does it include Molson-Coors, micro-breweries, Bordeaux wine, California Zinfandel, Perrier?

  4. Competitor Definition • Empirical Approaches • Cross price elasticity • η = ΔQy/Qy or dQy/dPx x Px/Qy ΔPx/Px • η = % change in demand of Product A % Change in price of Product B • Practical Approaches • Product performance • Occasion for use • Geographic market

  5. Market Structure • Concentration Ratio • NAICS (5): 4-firm CR • a (.20) + b (.20) + c (.10) + d (.10) = .6 • a (.40) + b (.10) + c (.05) + d (.05) = .6 • Herfindhal Index • ∑i(Si)2 • .04 + .04 + .01 + .01 = .10 • .16 + .01 + .0025 + .0025 = .175

  6. Market Structure (5.2) Herfindahl Index Price competition • Perfect competition <.2 Fierce • Monopolistic competition <.2 f(differentiation) • Oligopoly .2 - .6 f(rivalry) • Monopoly .6 + Light / f(entry) H = 1/n firms if equal market shares: 5 companies with 20% each  H = 1/5 = .2

  7. Market Structure • Legal (Antitrust) • SSNIP (Small but significant nontransitory increase in price • Price > 5% • Time > 1 year • Examples • CRTC, ref. cable TV, telecom. • BMW, Audi, Mercedes

  8. Perfect Competition • Many sellers • Homogenous products • Excess capacity

  9. Perfect Competition (5.3)(Excess Capacity) Plant cap. = 50,000; actual level 10,000 @ $700 = $7M Orders = increase by 10,000 by lowering price to $300 Scenario = Increase production to 20,000 additional units at $300 X 10,000 = $3M additional cost = $1M in VC contribution to FC = $2M Minimum price to fill the order = $100 (Avg VC) Below $100 no more price war.

  10. Monopoly(Optimal Pricing) • P = 100 – Q and MC = $10 • TR = PxQ = (100 – Q)x Q • TR = 100Q – Q2 • MR = dTR / dQ = 100 – 2Q • Optimal sales: dTR/dQ = 100 -2Q = 0 Q = 50, P = $50, ∏ = $2,000 • Optimal ∏: MR = MC 100-2Q = $10Q = 45, P = $55, ∏ = $2,025

  11. Monopolistic Competition • Many sellers • Differentiated products • Vertical differentiation • Better product across all segments • Horizontal differentiation • Better product for a given segment (need) or geography (location and traveling cost)

  12. Monopolistic CompetitionHorizontal differentiation (5.1) L __________________________R M0 M5 M10 Price = 5 and travel cost .5/mile N = 100 customers equally spaced from 0 to 10 miles. If P = $5 both firms (at L and R) have 50 customers If L = $4 and R = $5 the new equilibrium will be: 4 + .5M for L = 5 + .5(10-M) for R 4 + .5M for L = 5 + 5 - .5M for R 1M = 10 – 4 = 6 L gains 10 customers with a price drop of $1

  13. Monopolistic Competition Entry in monopolistic Mkt (5.4) * Ceteris Paribus ** ?

  14. Oligopoly • Only a few sellers • Contrary to previous models, pricing and production strategies affect other competitors • Equilibrium: • Cournot: Adjusting for quantities • Bertrand: Adjusting for prices

  15. OligopolyCournot Equilibrium

  16. Cournot Equilibrium • Adjust quantities based on anticipations • Assumptions • Market  P = 100 – Q • Same size, same cost • MC = $10 • Q1 = Q2 • TC1 = TC2 = $10Q1 = $10Q2

  17. Looking at firm 1 • Market: P = 100 – Q P = 100 – Q1 –Q2 • TR1: (100 - Q1 - Q2g)x Q1 • ∏1 : TR1 – TC1 • ∏1 : (100 - Q1 - Q2g)x Q1 – 10Q1 • ∏1 : (100Q1- Q12- Q1 Q2g)– 10Q1 • ∏1 : 90Q1 – Q12 –Q1Q2g • d∏1/dQ1: 90 – 2Q1 - Q2g = 0 • Q1: 45 - .5Q2g

  18. Cournot Reaction Function (5.2) Q2 Q1 = 45 - .5Q2g Q2 = 45 - .5Q1g R1 45 Q*2 = 30 R2 Q1 Q*1 = 30 45

  19. Algebraic Solution • Q1 = 45 - .5Q2g • Q2 = 45 - .5Q1g • At equilibrium • Q1 = Q1g and Q2 = Q2g • Q1 = 45 - .5(45 - .5Q1) • Q1 = 45 – 22.5 + .25Q1 • Q1 - .25Q1 = 45 – 22.5 • .75Q1 = 45 - 22.5 • Q1 = 30 • Thus P1 = 100 – Q1 –Q2 = $40

  20. Let’s Compare Cournot’s with Monopoly Pricing • Monopoly ∏: MR = MCQ = 45, P = $55, ∏ = $2,025 • Cournot ModelQ = 30, P = $40, ∏ = $900 • Vs Collaborative pricing: Q = 22.5, P = $55 = $1012.50 • Wealth Destruction/sub-optimal profit

  21. Cournot Equilibrium • P clears the market given firm’s production levels: P = 100 – Q1 –Q2 (i.e. No Inventory) • Q1 is firm 1 output given it guesses firm 2 output at Q2g • Q2 is firm 2 output given it guesses firm 1 output at Q1g

  22. OligopolyBertrand Equilibrium

  23. Bertrand Price Competition • Compete on Price, adjust quantities • Remember: Cournot equilibrium was competing on quantities and adjusting prices • Two situations: • Homogeneous goods • P = MC = 0 profit • Horizontal differentiation

  24. Bertrand Price Competition(Monopolistic Competition) • Coke (1) and Pepsi (2) Example • Q1 = 63.42 – 3.98 P1 + 2.25P2 • Q2 = 49.52 – 5.48 P2 + 1.40P1 • ∏1 = (P1 – 4.96) (63.42 – 3.98 P1 + 2.25P2g) • ∏2 = (P2 – 3.94) (49.52 – 5.48 P2 + 1.40P1g) Gasini, Lafont, Vuong, (1992)

  25. Bertrand Price Competition(Monopolistic Competition) • ∏1 = (P1 – 4.96) (63.42 – 3.98 P1 + 2.25P2g) = 63.42P1 – 3.98P12 + 2.25P1P2g - 314.56 + 19.74P1 – 11.16P2g = 83.16P1- 3.98P12 + 2.25P1P2g– 314.56 - 11.19P2g • d∏1/dP1 = 83.16 - 7.96P1 + 2.25P2g = 0 7.96P1 = 83.16 + 2.25P2g • P1 = 10.44 + .2826 P2g

  26. Derivative and rate of change Y = K + bX dY/dX = b

  27. Bertrand Price Competition(Monopolistic Competition) Optimal profit functions for Coke and Pepsi • P1 = 10.44 + .2826 P2g • P2 = 6.49 + .1277 P1g • Now we need to solve for P1 and P2

  28. Bertrand Price Competition(Monopolistic Competition) • P1 = 10.44 + .2826 P2g (1) • P2 = 6.49 + .1277 P1g (2) • P1 = 10.44 + .2826 (6.49 + .1277P1) • P1 = 10.44 + 1.834 + .036P1 • P1 - .036P1= 10.44 + 1.834 • P1 = 12.44 • Solving for Firm 2: P2 = $ 8.11

  29. Bertrand Equilibrium (5.3) P2 Firm 1 P1 = 10.44 + .2826 P2g P2 = 6.49 + .1277 P1g $8.11 Firm 2 $6.49 P1 $10.44 $12.72

  30. Cournot and Bertrand Cournot Bertrand Cutthroat No capacity constraint Flexible capacities Can steal business Over capacity (cycles) P = MC (No diff.) Short term • Equilibrium • Capacity  Price • Production Decisions • Planned sales • Sunk costs and Inventory costs • Function at capacity • No business stealing • Long Term

  31. Cournot or Bertrand Cournot Bertrand Q = f(P) • P = f(Q)

  32. Cournot or BertrandSteps • Define revenue function (PQ) • Define profit function (P-MC)(Q) • Optimize the profit function (d∏/dQ for Cournot or d∏/dP for Bertrand = 0) • Isolate Q (for Cournot) and P (for Bertrand) for both firms • Solve for Q or P for both firms • Calculate complements (P and Q), sales and profits for both firms • Analyse results and discuss consequences

  33. Price and Concentration • Price level = f(market structure) • Cournot  • Price = f(Herfindahl and capacity) • Bertrand  • Price = f(Differentiation and overcapacity) • Number of firms and pricing

  34. Structure:Pricing (1) • Leonard Weiss • Higher prices in concentrated markets • When top three gasoline retailers had market share > 60%, prices were 5% higher compared to other markets where top three retailers had a 50% share

  35. Structure:Pricing (2) • Bresnahan and Reiss • Service industries (doctors, tire dealers, plumbers....) • Market entry threshold • En = Minimum population to support n service providers • E2 is about 4 times E1 (doubled demand to compensate for reduced prices) • E3 – E2 > E2 – E1 (competition more intense with 3) • E4 – E3= E3 – E2 (price competition is close to max.) • Three firms are sufficient for optimal price competition

  36. Structure:Pricing Range (3) Monopoly  MR = MC Perfect Competition  P = MC MC AC Pm Ppc D = AR Qm Qpc MR Market Demand and Firm Cost Structure

  37. Wrap up • Mkt definition and competitors • Criteria • Concentration, Herfindhal Index • Cross elasticity • Pricing issues • Perfect / oligopolistic competition • Monopoly • Oligopoly • Cournot equilibrium • Bertrand equilibrium

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