Economics of Strategy Market Structure and Dynamic Competition

Defining Markets “that set of suppliers and demanders whose trading practices establishes the price of a good” –George Stigler and Robert Sherwin

Close substitutes same or similar product performance characteristics same or similar occasions for use same geographic market

Product performance characteristics subjective analysis of “similar” products to reduce subjectivity, list the attributes which you believe are most influential in the consumers purchase decision

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

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?

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

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

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

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 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 –How fast do competitors disappear and appear?

Hirfindahl Index

Market Structures Chart

Market Structure and Dynamic Competitive Forces 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 Schumpeter’s “gale of creative destruction”

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 PRICE TAKERS

Zero Profit Condition With perfect Competition economic profits are driven to zero 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 = 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 –Competitive –Contestable Markets exist

Many Sellers With many sellers, cartels and collusive agreements difficult to create/maintain 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 Make for better substitutes! –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 Customers switching from a competitor is likely to be the largest source of revenue gain

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 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

Monopoly A monopolist faces little or no competition in the product market Monopolist can act in an unconstrained way in setting prices A monopolist profit maximizes –equilibrate marginal revenue and marginal costs –price on the demand curve PRICE SEARCHERS

Monopoly and Output A monopolist perpetually understocks 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 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 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 Unlike under perfect competition, in monopolistic competition each firm’s demand curve is downward sloping rather than flat Usually very elastic demand for the firm - 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 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 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 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 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 that are not well differentiated) the market mimics pure competition and 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