Economics of Strategy Slide show prepared by Richard PonArul California State University, Chico  John Wiley  Sons, Inc. Chapter 6 Competitors and Competition Besanko, Dranove, Shanley and Schaefer, 3 rd 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

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

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 Q 1 and Q 2 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