1. Lecture 3: MARKET STRUCTURE AND PRODUCT DIFFERENTIATION AEM 4160: Strategic Pricing Prof. Jura Liaukonyte 1

2. Lecture Plan Market Concentration Product Differentiation Price Discrimination 1 2 3 Income Elasticity Cross Price Elasticity Price Elasticity of Supply What does it mean How to measure Why do we care? HHI, CR4-Ratio, Lerner Index Differentiation and market structure Implications for pricing First Degree PD Second Degree PD Other Elasticities 4

3. Other Demand Elasticities  Income Elasticity of Demand  Measures how much quantity demanded changes with a change in income

4. Values for Income Elasticity (E I )  Sign indicates normal or inferior.  E I  >0 implies normal good.  E I  <0 implies inferior good.  Normal goods may be necessity or luxury.

5. Other Demand Elasticities  Cross-Price Elasticity of Demand  Measures the percentage change in the quantity demanded of one good that results from a one percent change in the price of another good

6. Other Demand Elasticities  Complements: Cars and Tires  Cross-price elasticity of demand is negative  Price of cars increases, quantity demanded of tires decreases  Substitutes: Butter and Margarine  Cross-price elasticity of demand is positive  Price of butter increases, quantity of margarine demanded increases

7. Illustration: Cross Price Elasticity Two Substitutes Two Complements Demand for Product B Price of Product A Demand for Product Y Price of Product X

8. Size of shift in Demand E XY >1 E XY <1 Demand for Product Price Demand for Product D D’ D Assume P subst Increases Price

9. Example: The Cross-Price Elasticity of Demand for Cars  Source: Berry, Levinsohn and Pakes, "Automobile Price in Market Equilibrium," Econometrica 63 (July 1995), 841-890.

10. Price Elasticity of Supply  Measures the sensitivity of quantity supplied given a change in price  Measures the percentage change in quantity supplied resulting from a 1 percent change in price DefinitionFormula

11. Profit Maximization: MR=MC Optimization Set Up profit(q) = TR(q) – TC(q) How to maximize profit?

12. Profit Maximization: MR=MC Optimization Set Up profit(q) = TR(q) – TC(q) Profit maximization: dprofit/dq = 0 This implies dTR(q)/dq - dTC(q)/dq = 0 But dTR(q)/dq = marginal revenue dTC(q)/dq = marginal cost So profit maximization implies MR = MC

13. Profit Maximization: Monopoly Condition Derivation of the monopolist’s marginal revenue $/unit Quantity Demand MR A With linear demand the marginal revenue curve is also linear with the same price intercept … but twice the slope 1. Demand: P = A – B*Q 2. Total Revenue: TR = P*Q = A*Q – B*Q 2 3. Marginal Revenue: MR = dTR/dQ 4. MR= A-2B*Q

14. Market Concentration  Numbers and size distributions of firms  Ready-to-eat breakfast cereals: high concentration  Newspapers: low concentration 2 Different Market Structures Measurements of market structures 1. Concentration ratio, 2. Herfindahl-Hirschman Index (HHI) 3. Lerner Index (LI)

15. Industry Concentration  Four-Firm Concentration Ratio  The sum of the market shares of the top four firms in the defined industry. Letting S i denote sales for firm i and S T denote total industry sales  Herfindahl-Hirschman Index (HHI)  The sum of the squared market shares of firms in a given industry, multiplied by 10,000: HHI = 10,000   w i 2, where w i = S i /S T.

16. HHI  The Herfindahl-Hirschman Index – the square of the percentage market share of each firm summed over the largest 50 firms in the industry (or all of the firms if there is less than 50) Definition Properties Example In perfect competition, the HHI is small In monopoly, the HHI is 10,000 (100 squared) A popular measure with the Justice Dept in the 1980’s HHI < 1000 characterized competitive markets HHI > 1800 would bring Justice Dept challenge to proposed mergers E.g. The cigarette industry is highly concentrated with only 8 firms and a Herfindahl-Hirschman Index (HHI) of 2623

17. Measure of concentration 17 1 25 1 25 2 25 2 25 3 25 3 25 4 5 4 5 5 5 5 5 6 5 6 5 7 5 7 5 8 5 8 5 625 625 625 25 25 25 25 25 Concentration Index Firm Rank Market Share (%) Squared Market Share

18. 125625 225625 325625 4525 55 65 75 85 Measure of concentration 18 Concentration Index Firm Rank Market Share (%) Squared Market Share Σ Σ CR 4 = 80 H = 2,000

19. 125625 225625 325625 4525 55 65 75 85 Measure of concentration 19 Concentration Index Firm Rank Market Share (%) Squared Market Share Assume firms 4 and 5 merge

20. 125625 225625 325625 4525 55 65 75 85 Measure of concentration 20 Concentration Index Firm Rank Market Share (%) Squared Market Share Σ Σ Assume firms 4 and 5 merge 10 100

21. 125625 225625 325625 4525 55 65 75 85 Measure of concentration 21 Concentration Index Firm Rank Market Share (%) Squared Market Share Σ Σ CR 4 = 80 H = 2,000 The concentration indices change 10 100 852050

22. Example: Credit Card Industry

23. Market Definition  All Credit Lending Institutions with their own card  27.2%J.P. Morgan Chase & Co.  19.2% Bank of America Corporation  18.9% Citigroup Inc.  17.2% American Express Company  4.0% Capital One  CR4: 83.2  HHI: 1810-1850  Total Number of Companies: 192

24. What is a Market?  No clear consensus  the market for automobiles  should we include light trucks; pick-ups SUVs?  the market for soft drinks  what are the competitors for Coca Cola and Pepsi?  With whom do McDonalds and Burger King compete?  Presumably define a market by closeness in substitutability of the commodities involved  how close is close?  how homogeneous do commodities have to be?

25. Fast-Food Outlets Burger King McDonald’sWendy’s

26. Market Performance  Market structure is often a guide to market performance  But this is not a perfect measure  Can have near competitive prices even with “few” firms  Measure market performance using the Lerner Index LI = P-MC P

27.  Lerner Index: L = (p - MC)/p = 1/|E P |  The higher the number, the more pricing power the firm has.  Mark-up power reflects monopoly power.  PUNCHLINE: If elasticity increases, mark-up will decline. If the product becomes less elastic, mark- up will increase. Lerner Index

28. What are Sources of Monopoly Power? Low elasticity of demand We just showed this using Lerner Index. Possibly due to strong product differentiation. High barriers to entry e.g., ownership of necessary raw materials, patents and regulatory barriers, scale economies, product diff. Number of other competitors in market. Interactions between firms: Compete or cooperate?

29. Product Differentiation  Products are different if there is some objective characteristic or property, real or perceived, that provides a basis for buyers to choose one over the other.  Product differentiation may lead to reduced own -price elasticity. As the degree of differentiation increases, the price elasticity will decrease.

30. Product Differentiation, cont.  Ways in which products are differentiated.  Product Brand  Packaging  Conditions of Sale  Service Provided  Location  Product Differentiation as an Entry Strategy  Product differentiation to create a niche market.  Product differentiation to deter entry.

31. Product Positions in Characteristics Space