1. Competitors and Competition
Besanko, Dranove, Shanley, and Schaefer
Chapters 6

2. Agenda Competitor Identification Measuring Market Structure
Market Structure and Competition
Perfect Competition
Monopoly
Monopolistic Competition
Oligopoly

3. Competitor Identification
One way of identifying competitors is to examine the cross-price elasticity of demand.
yx = (∂Qy/Qy) / (∂Px/Px)
yx = (Qy/Qy) / (Px/Px)
If this is positive, then the goods are considered substitutes.

4. Direct vs. Indirect Competitor
A direct competitor is one whose strategic choices directly affect the other company.
An indirect competitor is one who affects your company through the strategic choices of a third company.

5. Conditions For Being Close Substitutes
Competing products have the same or similar product performance characteristics.
Competing products have the same or similar occasions for use.
Competing products are sold in the same geographic market.

6. Differing Geographic Market Conditions
Products are said to be in different geographic markets if they are:
Sold in different locations.
Costly for either the producer or consumer to transport the goods.

7. Market Definition
It identifies the market(s) in which the firm compete(s).
Two firms are said to exist in the same market if they constrain each other’s ability to raise price.

8. Measuring Market Structure
Market structure is the number and distribution of companies in a market.
The concentration level of the companies in your market can have a direct effect on your pricing strategy.
Two measures:
N-Firm Concentration Ratio
The Herfindahl Index

9. N-Firm Concentration Ratio
The N-Firm Concentration Ratio gives the combined market share of the N largest firms.
A problem with this measure is that it does not take into consideration the proportions of each of the N largest companies.
Hence a shift of market share from one large firm to another goes unnoticed.

10. The Herfindahl Index
The Herfindahl Index (HFI) is defined as the summation of the squared market shares of all firms in the market.
HFI = i (Si)2 = S12 + S22 + … + SN2
Where Si is the market share for firm i.
This index will account for changes in market share between companies.
The reciprocal of the HFI is known as the numbers-equivalent of firms, which in essence tells you how many firms the market appears to have.

11. Market Structure and Competition
Market competition is usually broken up into the following four general areas:
Perfect Competition
Monopoly
Monopolistic Competition
Oligopoly

12. Market Structure and Herfindahl Index
Perfect and Monopolistic Competition tend to be seen in industries with a HFI index less than 0.2.
Oligopolies usually have a HFI between 0.2 and 0.6.
Monopolies tend to have HFI equal to 0.6.

13. Perfect Competition
Perfect Competition is said to exist if the following conditions hold:
Homogeneous products
No barriers to entry or exit
Large number of buyers and sellers
Perfect information
No collusion between the sellers or buyers
No externalities (Perloff, Microeconomics)
Transaction costs are low (Perloff, Microeconomics)

14. Homogeneous Product
A homogeneous product is a good that has a perfect substitute, i.e., it does not matter who produced the good because the good appears to be the same no matter who produced it.
E.g., #2 Yellow Corn, clothes pin

15. No Barriers to Entry or Exit
No barriers to entry or exit implies that anyone can enter or exit the market without substantial cost.
Farming can be perceived as having an ever increasing barrier to entry which is the high cost to acquire the land.

16. Large Number of Sellers
The key to this condition for competition is that no particular seller has the ability to affect the market because of her decisions.

17. Perfect Information
There must exist for all participants information regarding prices, quantities, qualities, etc.
With the internet and the idea of precision farming, all the sectors in the economy are moving closer to this condition.

18. No Collusion
Collusion occurs when people get together as a group and make decisions that affect the market.
E.g., OPEC, stores that run ads regarding price matching

19. No Externalities
An externality “occurs when a person’s well-being or a firm’s production capability is directly affected by the actions of other consumers or firms rather than indirectly through changes in prices.” (Perloff, Microeconomics)
E.g., Odor from a farm, pesticide drift

20. Low Transaction Costs
“Transaction costs are the expenses of finding a trading partner and making a trade for a good or service other than the price paid for that good or service.” (Perloff, Microeconomics)
E.g., having two sellers a great distance apart.

21. Competitive Firms
Competitive firms tend to operate where price is equal to marginal cost implying that there PCM is at zero.
They are always in fierce pricing competition with other firms in their market.
Competitive firms are usually not able to set prices, they take prices as given.

22. Monopoly
A monopoly exists if there is little competition in its output market or input market.
Monopolist relates to output markets.
Monopsonist relates to input markets.
A monopoly does not have to be the only firm in a market.
The key is that other firms cannot sufficiently affect it through there actions.

23. Monopoly Cont.
Monopolies have the ability to affect price through there output decisions.
Being a monopoly does not necessarily mean that you can charge monopoly prices.
It depends on the level of potential competition.

24. Monopoly Cont.
Monopolies also have varying levels of price discriminatory power.
If the monopoly cannot distinguish between buyers, it must use the market demand curve to set one price.
A perfectly discriminatory monopoly would charge each buyer there marginal gain for each output level.

25. A Monopoly Problem Suppose a monopoly existed in the emu industry.
Currently the firm that sells emu has a variable cost of $10 for each emu and is facing a demand curve for their product of P(Q) = 100 – 2*Q.
What is the optimal amount of emus to produce and what is the optimal price.
Assume there are no fixed costs.

26. Monopoly Solution The goal is to maximize profits ().
 = Total Revenue – Total Cost
 = P(Q)*Q – VC*Q
 = (100-2Q)*Q – 10*Q
 = (100*Q-2Q2) – 10*Q
∂/∂Q = Q = 0
This implies optimal output occurs at 22.5 and optimal price equals 55.

27. Monopolistic Competition
Monopolistic competition is characterized by having most of the same conditions as perfect competition, where the only difference is that the products are viewed by the consumer to have slightly different characteristics, i.e., the products are differentiated.

28. Differentiation in Monopolistic Competition
Vertical Differentiation
When a product has characteristics that make it unambiguously better or worse than a competing product.
Horizontal Differentiation
When a product has characteristics that some consumers prefer over a competing product.

29. Differentiation in Monopolistic Competition Cont.
Even if two products are homogenous, they still could be differentiated by geographic location.

30. Geographic Differentiation Example
Suppose you have two sellers of ice cream where their products have the same physical characteristics.
Seller A is located at the north end of town, and seller B is located at the south end of time.
Suppose these two sellers are 10 miles apart.

31. Geographic Differentiation Example Cont.
Assume that there are three customer bases in the city.
Customer base 1 is located 4 miles from seller A and 5 miles from seller B.
Customer base 2 is located 5 miles from seller A and 5 miles from seller B.
Customer base 3 is located 6 miles from seller A and 4 miles from seller B.

32. Geographic Differentiation Example Cont.
If it costs $1 per mile to travel, which store would each consumer base go to?
What would happen if seller B lowered his price by $0.50?
What would you need to know to know if seller B is better off?

33. Oligopoly
Oligopoly markets are characterized by a few large producers controlling most of the market.
The action of just one company can have an effect on the industry price.
There are generally two types of competition considered with oligopolies:
Cournot Quantity Competition
Bertrand Price Competition

34. Cournot Quantity Competition
In this type of competition, each firm chooses how much output it will produce.
After quantity has been chosen, they consider what price to charge to clear the market.

35. Cournot Quantity Competition
Cournot competition is characterized by each firm developing a best response to what it thinks its rival will do.
It does this by developing a reaction function.
A reaction function is a response function to what you believe your competitor is going to do.

36. Cournot Equilibrium
A Cournot Equilibrium is the outputs and market price that satisfy the following two conditions:
The equilibrium price is the price that clears the market given the firms’ production levels.
The equilibrium quantity of each firm is the best response to the equilibrium quantity chosen by the other firms.
Best response means that there is no better choice given your competitors strategy.

37. Cournot Equilibrium Example
Suppose there are only two firms in the market using the same technology and has the same costs.
Suppose the market demand is the following:
P = 100 – Q
Where Q is the total quantity in the market.
Also assume that the cost for each unit produced by each firm is $10 per unit of output.

38. Cournot Equilibrium Example Cont.
What is the Cournot Equilibrium price and quantity for each firm?
Answer will be worked out in class.
Note: Cournot Competition does not maximize industry profits.

39. Bertrand Price Competition
Unlike the Cournot Model, the Bertrand price model has the firm choosing price rather than quantity.
Due to this price competition, price is pushed down to marginal cost.
The key to obtaining this solution is that the products are perfect substitutes.

40. Bertrand Versus Cournot
The Cournot model considers a two stage decision process where output is first chosen and then price is considered, while the Bertrand model assumes that price is set and each firm then sets quantity.
The Bertrand model is related more to industries that have flexible production capacity.