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

2. Introduction Market structure affects market competition
highly concentrated markets tend to be stable
unconcentrated markets tend to be more competitive
In order to identify structure need to:
identify competitors
define the market

3. Market Definition
A market is that set of suppliers and demanders whose trading establishes the price of a good.
Firms are in the same market if they constrain each other’s ability to raise price
Market definition lies at the heart of antitrust policy
compute market shares to identify market power
but then need to know the size of the market
so need to define the market

4. Market Definition
Simple conceptual guideline followed by anti-trust authorities: merger with all the competitors should lead to a small but significant nontransitory increase in price (SNIP criterion)
Small, but significant = 5% for US DoJ
5 to 10% for EU
In practice, two firms can be said to compete if a price increase by one firm drives its customers to the other firm

5. Market definition (cont.)
Start with a “thought experiment”
suppose all firms in the supposed market could coordinate their prices
would they choose to raise prices by at least 5%?
if yes then there are few “outside” competitors
the market is well defined
Related to own-price elasticity of demand
If ŋx is “small” then sellers
face few constraints on
their ability to raise prices.
% change in quantity demanded of x
ŋx = -
% change in price of x

6. Market definition (cont.)
This approach relies on group elasticity
individual product elasticity might be high
RAS o Generali o Toro
but group elasticity would be low
if all three increase prices together they will lose little custom

7. 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

8. 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

9. Characteristics of Substitutes
Two products tend to be close substitutes when these 3 criteria are jointly satisfied:
They have similar performance characteristics
They have similar occasion for use and
They are sold in the same geographic area

10. 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

11. 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

12. Competitor identification (cont.)
The 3 qualitative criteria can be supplemented by quantitative data
direct estimates of cross-price elasticities
price correlation
prices of substitute products tend to move together over time
allocated to the same Industrial Classification code
but at what level?
pharmaceuticals are in SIC code 2834
but not all drugs are substitutes
and competitors can be allocated to different SIC codes

13. 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

14. 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

15. 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

16. 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

17. Measuring Market Structure
A common measure of concentration is the N-firm concentration ratio - combined market share of the largest N firms
CR4 = Si Si where Si is firm’s i market share and
i= 1, …4
Herfindahl index is another which measures concentration as the sum of squared market shares
H = Si Si where
i = 1,…….n (n is total number of firms in the market)

18. Four Classes of Market Structure

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. Theory of Monopolistic Competition

37. 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

38. 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

39. 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

40. 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

41. 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

42. Cournot Duopoly
In the Cournot model each of the two firms pick the quantities Q1 and Q2 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)

43. Cournot Reaction Functions

44. 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

45. 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

46. 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

47. Bertrand Reaction Functions

48. 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

49. 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

50. 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

51. 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

52. 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)

53. 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

54. 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

55. 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

56. 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