Economics of Strategy Market Structures and Dynamic Competition

Substitutes and Cross-Price Elasticity “In general, two products X and Y are substitutes if, when the price of X increases and the price of Y stays the same, purchases of X go down and purchases of Y go up.” Individuals substitute continually Economists measure this relationship with the “cross-price elasticity”

Cross-Price Elasticity % change in the quantities of Y E cp % change in the price of X How are the quantities sold in the market for automobiles affected by changes in the relative price of trucks?

Products tend to be close substitutes when we observe… same or similar product performance characteristics same or similar occasions for use same geographic market

Product performance characteristics subjective analysis of “similar” products so definition of the market becomes debatable to reduce subjectivity, list the attributes which you believe are most influential in the consumers purchase decision Difficult to say to what degree they are substitutes –Use cross-price elasticities Role of transactions and transportation costs?

Occasions for use Where is the product used? When is the product used? How is the product used?

Where? Geographic Market Is the product sold by competitors where customers –are not affected by transportation costs costs of time for the consumer to travel to an alternative location to purchase costs of shipping the product to the customers location –are not affected by tax differences –convenience is not a major factor

When is the product used? Different demands during different hours, days, weeks, months, seasons –Golf Course prices in SW Florida –Phone services –Hotel/Motel accommodations

How is the product used? To listen to music… –Radio –CD Player –Tape Player –Eight…. No don’t go there –MP3 Files –Napster

Problems in Identifying Substitutes identifying precise product performance characteristics is subjective and imprecise does not answer “how good a substitute is it?” –Use elasticity to solve this Transaction or transportation costs can be influential convenience can be influential but the price customers are willing to pay for it is subjective

Defining Markets “that set of suppliers and demanders whose trading practices establishes the price of a good” –George Stigler and Robert Sherwin Do the firms constrain one another’s ability to affect price?

Defining the Market Market definition is the identification of the market(s) in which the firm is a player Two firms are in the same market if they constrain each other’s ability to raise the price It is important to define the market if market shares need to be computed (for anti-trust economics or business strategy formulation)

Well-Defined Market If the market is well defined, firms outside the candidate market will not be able to constrain the pricing behavior of those inside A thought experiment: If all the firms inside the candidate market colluded, can they raise the price by at least 5%? If they can, the market is well defined

Coca Cola’s Market Is Coca Cola’s market, the market for cola drinks or the market for all potable liquids (including tap water)? In the face of anti-trust concerns, Coke would have preferred the broader definition Judicial system found the carbonated drinks market to be the relevant one

Firm Elasticity or Industry/Market Elasticity? Clearly differentiate –If I know the industry has a high cross-price elasticity it means that if industry prices rise people will substitute other products for my industries’ good or service –This tells us nothing about firm elasticity's within the industry, which is what firms are often interested in

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 Geographic Competitors First – Where do your customers come from (define the “catchment” area) Second - Where do the customers in the catchment area shop? With the technological innovations, the catchment area widens –Catalogue Sales –Internet Sales

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 –How fast do competitors disappear and appear?

Herfindahl Index

Rank all market shares from highest to lowest Square all market shares and sum –Produces larger “penalties” for large market shares

Market Structures Handout –Perfect Competition –Monopolistic Competition –Oligopoly –Monopoly

Market Structure and Dynamic Competitive Forces A monopoly market may produce the same outcomes as a competitive market (due to the threat of entry) A market with as few as two firms can exhibit fierce competition Competition as Process –Schumpeter “the gale of creative destruction” –Von Hayek “How easy it is for the inattentive manager to allow profits to slip away” –Innovation and progress

Perfect Competition Assumptions –Many sellers who sell a homogenous product –Buyers and sellers are well-informed buyers (“perfect knowledge”) –Sellers can enter and exit freely –Often “large numbers of buyers and sellers” – but not always Produces PRICE TAKERS where each firm faces a perfectly elastic demand

Dynamic Condition - Zero Profits over the Long Run Economic profits are driven towards zero due to entry and exit Percentage contribution margin or per unit profits PCM = (P - MC)/P –where P is price and MC is marginal When profits are maximized PCM = 1/  –where  is the elasticity of demand Since  is infinity, PCM approaches 0 in the limit

Conditions for Fierce Price Competition Even if these ideal conditions are not present, price competition can be fierce when –There are many sellers –The product is perceived to be homogenous –Excess capacity exists –Contestable Markets exist

Many Sellers With many sellers, collusive agreements become difficult to create and maintain Cartels fail eventually because some players will be tempted to cheat because –Effective cartels raise prices and profits –Small cheaters may go undetected

Price Even if the industry PCM is high, a low-cost producer may prefer to set a low price “Remember the Demand Curve” Davey Elasticity Crockett Raises prices against anything but a perfectly inelastic demand curve means losing quantities

Homogenous Products Make for better substitutes! –Customers are more likely to price shop when the product is perceived to be homogenous –Hence, customer switching may be the largest source of revenue gain this will create great interdependence in pricing and high levels of competition among firms in the industry

Excess Capacity When a firm is operating below full capacity it can price below average cost and operate with economic losses for some time period so long as the price covers variable costs If industry has excess capacity, prices may 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 can persist

Contestable Markets the viable threat of competition from interloper firms is enough to keep firms acting as if it had actual competitors. Critical role of entry to dissipate profits Low barriers to entry required “Hit-and-Run” entry results

Monopoly The sole producer of a product for which there are no good substitutes A monopolist faces little or no competition in its product market A monopolist can set price – but is still subject to the demand curve A monopolist profit maximizes –equilibrate marginal revenue and marginal costs –price on the demand curve PRICE SEARCHERS

Monopoly and Output A monopolist perpetually under stocks the market and charges too high a price - Adam Smith Price exceeds the competitive price Price exceeds the marginal costs of production Output is below the competitive level

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, continued… Monopolists are more likely to be innovative (relative to firms facing perfect competition) because they can capture some of the benefits of successful innovation Since consumers also benefit from these innovations, they can actually be 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 Under monopolistic competition each firm’s demand curve is downward sloping rather than horizontal but it is very elastic for the firm – due to the availability of many close substitutes

Vertical and Horizontal Differentiation Vertically differentiated products unambiguously differ in quality Horizontally differentiated products vary in certain product characteristics to appeal to distinct 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 their “transportation costs” Transportation or transactions 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 the consumers’ physical location and the product characteristic will be analogous to store location

Spatial Differentiation “Transportation costs” can be viewed as the cost of the mismatch between the consumers’ tastes and the product’s attributes Products are not perfect substitutes for each other and for consumers some products are better substitutes than others – i.e., they have low “transportation costs”

Monopolistic Competition Many firms with non-interdependent price and quantity decisions Many buyers Low barriers to entry and exit Close, but differentiated, substitutes –Burger King has a monopoly on “The Whopper” but there are many close substitutes

Theory of Monopolistic Competition An important determinant of a firm’s demand is customer switching – if products are viewed as close substitutes switching is more likely 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 or how likely consumers are to switch

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 short run economic profit But ease of entry with short run economic profits will attract new entrants until each firm economic profit is zero Long run 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 (where products are not well differentiated) the market mimics pure competition and the erosion of economic profits is rapid

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 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 of stealing business At some point (with 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: 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 60% share, prices were 5 percent higher compared to markets where the top three had a 50% 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 exhibit 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 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