Economics of Strategy

Slide show prepared by

Richard PonArulCalifornia State University, Chico

John Wiley Sons, Inc.

Chapter 6

Competitors and Competition

Besanko, Dranove, Shanley and Schaefer, 3rd Edition

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

Identifying Competitors

Mergers with all the competitors should lead to a significant non-transitory increase in price (DOJ guideline)

In practice, two firms can be said to compete if a price increase by one firm drives its customers to the other firm

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– 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

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

Herfindahl index is another which measures concentration as the sum of squared market shares

Entropy could be another measure of concentration

Four Classes of Market Structure

Structure Herfindahl Index Intensity of Price Competition Perfect Competition

Usually < 0.2 Fierce

Monopolistic Competition

Usually < 0.2 Depends on the degree of product differentiation

Oligopoly 0.2 to 0.6 Depends on inter-firm rivalry Monopoly > 0.6 Light unless there is threat of

entry

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

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 inter-industry 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 price-cost 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