Economics of Strategy Sixth Edition Copyright  2013 John Wiley  Sons, Inc. Chapter 5 Competitors and Competition Besanko, Dranove, Shanley, and Schaefer

Competition If one firm’s strategic choice adversely affects the performance of another they are competitors A firm may have competitors in several input markets and output markets at the same time Competition can be either direct or indirect

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

Identifying Competitors DOJ Guideline: Merger with all the competitors should lead to a small but significant non-transitory increase in price (SSNIP)  Small: At east 5%  Non-transitory: At least for one year

Identifying Competitors In practice any one who produces a substitute product is a competitor 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 Performance characteristics describe what the product does to the customer Example from automobiles  Seating capacity  Curb appeal  Power and handling  Reliability

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: Hiking shoes versus court shoes

Empirical Approaches to Competitor Identification Cross price elasticity of demand Pattern of price changes over time Firms in the same Standard Industrial Classification (SIC)

Standard Industrial Classification (SIC) Products and services are identified by a seven digit code Each digit represents a finer degree of classification Products that belong to the same genre or the same SIC need not be substitutes

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

Identifying Competitors in the Area Step 1: Locate the catchment area. (where the customers come from) Step 2: Find out where the residents of the catchment area shop With some products like books and drugs being sold over the internet identifying geographic competition becomes more difficult

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

Measures of Market Structure The N-firm concentration ratio (the combined market share of the largest N firms) Herfindahl index (the sum of squared market shares) When the relative size of the largest firms is important Herfindahl is likely to be more informative

Four Classes of Market Structure

Perfect Competition Many sellers who sell a homogenous good Many well informed buyers Consumers can costlessly shop around Sellers can enter and exit costlessly Each firm faces infinitely elastic demand

Zero Profit Condition With perfect competition economic profits go to zero When profits are maximized percentage contribution margin or PCM = 1/  where  is the elasticity of demand In perfect competition  is infinity and hence 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 Even when the industry is profitable, a low cost producer may prefer to set a low price With many sellers, cartels and collusive agreements harder to create and sustain Small players will be tempted to cheat and small cheaters may go undetected

Homogeneous Products Three sources of increased revenue when price is lowered  Customers buying more  New customers buying  Customers switching from the competitors

Excess Capacity When a firm is operating below full capacity it can price below average cost to cover 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 output market Monopolist can act in an unconstrained way in setting prices or quality, subject to demand If some fringe firms exist, their decisions do not materially affect the monopolist’s profits

Monopoly A monopolist faces a downward sloping demand curve 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

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

Geography and Horizontal Differentiation 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

Idiosyncratic Preferences Horizontal differentiation is possible with idiosyncratic preferences Location and Taste are important sources of idiosyncratic preferences Search costs discourage switching when prices are raised

Search Costs and Differentiation Search cost: Cost of finding information about alternatives Low cost sellers try lower the search costs (Example: Advertising) Some markets have high search costs (Example: Physicians)

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

Monopolistic Competition and Entry 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

Monopolistic Competition and Entry Customer loyalty allows prices to exceed marginal cost and encourages entry Entry considered excessive if fixed costs go up due to entry without a reduction in prices If entry increases variety valued by customers, then entry cannot be considered excessive

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 Duopoly: An Illustration Both firms have constant marginal cost of $10 Demand curve: P = 100 – Q 1 – Q 2 Firm 1 chooses Q 1 to maximize profits taking Q 2 as given Reaction function: Q 1 = 45 – 0.5Q 2 Firm 2’s problem is a mirror image of Firm 1’s

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 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

Market Structure: Causes Theory would predict that the larger the minimum efficient scale (MES) of production the greater will be the concentration. If entry is not easy concentration will be the result Monopolistic competition would mean easier entry and larger number of firms

Endogenous Sunk Costs Consumer goods markets seem to have a few large firms and many small firms The number of large firms and the total number of firms depend more on advertising costs than production costs (Sutton) Advertising costs are endogenous sunk costs

Endogenous Sunk Costs Early in the industry’s life cycle many small firms compete The winners invest in their brand name capital and grow large The smaller firms can try to match the investment and build their own brands or differentiate their products and seek niches

Price-Cost Margins & Concentration Theory would predict that price-cost margins will be higher in industries with greater concentration There could be other reasons for variation in price-cost margins  Regulation  Accounting practices  Concentration of buyers

Price-Cost Margins & Concentration It is important to control for these extraneous factors 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 higher concentration For locally provided services (doctors, plumbers etc.) the “entry threshold” – population needed to support a given number of sellers – increases fourfold between 1 and 2 sellers

Evidence on Concentration and Price E n = entry threshold for n sellers For locally provided services E 2 is about four times E 1 E 3 - E 2 > E 2 – E 1 E 4 – E 3 = E 3 – E 2 Intensity of price competition reaches the maximum with three sellers (Bresnahan and Reiss)

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