Chapter 5 - Competitors and Competition

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Economics of Strategy

Fifth Edition

Slides by: Richard Ponarul, California State University, Chico

Copyright2010 John Wiley Sons, Inc.

Chapter 8

Competitors and Competition

Besanko, Dranove, Shanley, and Schaefer


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Competition

If one firms strategic choice adverselyaffects the performance of another they arecompetitors

A firm may have competitors in severalinput markets and output markets at thesame time

Competition can be either direct or indirect


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Direct and Indirect Competitors

Direct competitors: Strategic choice of onefirm directly affects the performance of theother

Indirect competitors: Strategic choice of onefirm affects the performance of the otherbecause of a strategic reaction by a third

firm


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Identifying Competitors

DOJ Guideline: Merger with all thecompetitors should lead to a small but

significant non-transitory increase in price(SSNIP)

Small: At east 5%

Non-transitory: At least for one year


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Identifying Competitors

In practice any one who produces asubstitute 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


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Performance Characteristics

Performance characteristics describe whatthe product does to the customer

Example from automobiles

Seating capacity

Curb appeal

Power and handling

Reliability


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Occasion for Use

Products may share characteristics but maydiffer in the way they are used

Orange juice and cola are beverages but usedin different occasions

Another example: Hiking shoes versus courtshoes


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Geographic Area

Identical products in two differentgeographic markets will not be substitutesdue to transportation costs

Bulky products like cement cannot betransported over long distances to benefitfrom geographic price difference


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Empirical Approaches to Competitor Identification

Cross price elasticity of demand

Pattern of price changes over time

Firms in the same Standard IndustrialClassification (SIC)


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Cross Price Elasticity

xx

yy

yxPP

QQ

/

/

If yx

is positive, consumers

purchase more of Y when theprice of X increases


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Patterns in Price Changes

Prices of close competitors tend to be highlycorrelated

Data on purchase patterns reveal howindividual consumers react when sellerschange their prices


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Standard Industrial Classification (SIC)

Products and services are identified by aseven digit code

Each digit represents a finer degree of

classification

Products that belong to the same genre orthe same SIC need not be substitutes


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Geographic Competitor Identification

When a firm sells in different geographicalareas, it is important to be able identify thecompetitor in each area

Rather than rely on geographicaldemarcations, the firm should look at theflow of goods and services across geographic

regions


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Identifying Competitors in the Area

Step 1: Locate the catchment area.(wherethe customers come from)

Step 2: Find out where the residents of the

catchment area shop

With some products like books and drugsbeing sold over the internet identifying

geographic competition becomes moredifficult


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Market Structure

Markets are often described by the degree ofconcentration

Monopoly is one extreme with the highest

concentration - one seller

Perfect competition is the other extremewith innumerable sellers


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Measures of Market Structure

The N-firm concentration ratio

(the combined market share of the largest Nfirms)

Herfindahl index (the sum of squaredmarket shares)

When the relative size of the largest firms isimportant Herfindahl is likely to be moreinformative


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Four Classes of Market Structure

Nature ofCompetition

Range ofHerfindahls

Intensity of PriceCompetition

Perfect

Competition

Usually < 0.2 Fierce

MonopolisticCompetition

Usually < 0.2 Depends on the degreeof product differentiation

Oligopoly 0.2 to 0.6 Depends on inter-firmrivalry

Monopoly > 0.6 Light unless there isthreat of entry


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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


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Conditions for Fierce Price Competition

Even if the ideal conditions are not present,price competition can be fierce when two ormore of the following conditions are met.

There are many sellers

Customers perceive the product to behomogenous

There is excess capacity


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Homogeneous Products

Three sources of increased revenue whenprice is lowered

Customers buying more

New customers buying

Customers switching from the competitors


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Homogenous Products

For firms that cut prices, customersswitching from a competitor are likely tobe the largest source of revenue gain

Customers will be less loyal to the sellersand sellers are more likely to compete onprice


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Excess Capacity

When a firm is operating below full capacityit can price below average cost to cover thevariable cost

If industry has excess capacity, prices fallbelow average cost and some firms maychoose to exit

If exit is not an option (capacity is industryspecific) excess capacity and losses willpersist for a while


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Monopoly

A monopolist faces little or no competitionin the output market

Monopolist can act in an unconstrained way

in setting prices or quality

If some fringe firms exist, their decisions donot materially affect the monopolists profits


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Monopoly

A monopolist faces a downward slopingdemand curve

Monopolist sets the price so that marginal

revenue equals marginal cost

Thus the monopolists price is above themarginal cost and its output below the

competitive level


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Monopoly and Output

The traditional anti-trust view is that limitedoutput and higher prices hurt the consumer.

A competing (Demsetz) view is that

consumers may benefit even at monopolyprices if the monopoly was the result ofproduct innovations and efficient

manufacturing.


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Monopoly and Innovation

A monopolist often succeeds in becomingone by either producing more efficientlythan 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


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Monopoly and Innovation

Monopolists are more likely to be innovative(than firms facing perfect competition) sincethey 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 monopolists profits are restricted


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Monopolistic Competition

There are many sellers and they believe thattheir actions will not materially affect theircompetitors

Each seller sells a differentiated product

Unlike under perfect competition, inmonopolistic competition each firms

demand curve is downward sloping ratherthan flat


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Geography and Horizontal Differentiation

Grocery stores attract clientele based ontheir location

Consumers choose the store based on

transportation costs

Transportation costs prevent switching forsmall differences in price


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Horizontal Differentiation

Figure 8.1: Sandwich Retailers in Linesville


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Idiosyncratic Preferences

Horizontal differentiation is possible withidiosyncratic preferences

Location and Taste are important sources of

idiosyncratic preferences

Search costs discourage switching whenprices are raised


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Search Costs and Differentiation

Search cost: Cost of finding informationabout alternatives

Low cost sellers try lower the search costs

(Example: Advertising)

Some markets have high search costs(Example: Physicians)


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Monopolistic Competition and Entry

Since each firms demand curve isdownward sloping, the price will be setabove marginal cost

If price exceeds average cost, the firm willearn economic profit

Existence of economic profits will attract

new entrants until each firms economicprofit is zero


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Even if entry does not lower prices (highlydifferentiated products), new entrants willtake away market share from the

incumbents The drop in revenue caused by entry will

reduce the economic profit

If there is price competition (products thatare not well differentiated) the erosion ofeconomic profit will be quicker


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Customer loyalty allows prices to exceedmarginal 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 bycustomers, then entry cannot be considered

excessive


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Oligopoly

Market has a small number of sellers

Pricing and output decisions by each firmaffects the price and output in the industry

Oligopoly models (Cournot, Bertrand) focuson how firms react to each others moves


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Cournot Duopoly

In the Cournot model each of the two firmspick the quantities Q1 and Q2to be produced

Each firm takes the other firms output as

given and chooses the output thatmaximizes its profits

The price that emerges clears the market

(demand = supply)


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Cournot Duopoly: An Illustration

Both firms have constant marginal cost of$10

Demand curve: P = 100 Q1Q2 Firm 1 chooses Q1to maximize profits taking

Q2 as given

Reaction function: Q1= 45 0.5Q2 Firm 2s problem is a mirror image of Firm

1s


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Cournot Reaction Functions


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Cournot Equilibrium

If the two firms are identical to begin with,their outputs will be equal

Each firm expects its rival to choose theCournot equilibrium output

If one of the firms is off the equilibrium,both firms will have to adjust their outputs

Equilibrium is the point whereadjustments will not be needed


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Cournot Equilibrium

The output in Cournot equilibrium will beless than the output under perfectcompetition but greater than under joint

profit maximizing collusionAs the number of firms increases, the

output will drift towards perfect

competition and prices and profits per firmwill decline


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Bertrand Duopoly

In the Bertrand model, each firm selects itsprice and stands ready to sell whateverquantity is demanded at that price

Each firm takes the price set by its rival asa given and sets its own price to maximizeits profits

In equilibrium, each firm correctly predictsits rivals price decision


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Bertrand Reaction Functions


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Bertrand Equilibrium

If the two firms are identical to begin with,they will be setting the same price as eachother

The price will equal marginal cost (same asperfect competition) since otherwise eachfirm will have the incentive to undercut the

other


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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 actualproduction) Cournot competition is theresult

In Bertrand competition two firms aresufficient to produce the same outcome asinfinite number of firms


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Bertrand Competition with Differentiation

When the products of the rival firms aredifferentiated, the demand curves aredifferent for each firm and so are the

reaction functions The equilibrium prices are different for each

firm and they exceed the respective marginal

costs


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Bertrand Competition with Differentiation

When products are differentiated, pricecutting is not as effective a way to stealingbusiness

At some point (prices still above marginalcosts), reduced contribution margin fromprice cuts will not be offset by increased

volume by customers switching


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Market Structure: Causes

Theory would predict that the larger theminimum efficient scale (MES) ofproduction the greater will be the

concentration. If entry is not easy concentration will be the

result

Monopolistic competition would meaneasier entry and larger number of firms


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Endogenous Sunk Costs

Consumer goods markets seem to have a fewlarge firms and many small firms

The number of large firms and the total

number of firms depend more onadvertising costs than production costs(Sutton)

Advertising costs are endogenous sunk costs


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Endogenous Sunk Costs

Early in the industrys life cycle many smallfirms 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


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Price-Cost Margins & Concentration

Theory would predict that price-costmargins will be higher in industries withgreater concentration

There could be other reasons for variation inprice-cost margins

Regulation

Accounting practicesConcentration of buyers

i i i


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Price-Cost Margins & Concentration

It is important to control for theseextraneous factors to study the relationbetween concentration and price-cost

margin Most studies focus on specific industries and

compare geographically distinct markets

id i d i


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Evidence on Concentration and Price

For several industries, prices are found to behigher in markets with higher concentration

For locally provided services (doctors,

plumbers etc.) the entry threshold population needed to support a givennumber of sellers increases fourfoldbetween 1 and 2 sellers

id C i d i


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Evidence on Concentration and Price

En= entry threshold for n sellers

For locally provided services E2is about fourtimes E1

E3- E2> E2E1 E4E3= E3E2 Intensity of price competition reaches the

maximum with three sellers (Bresnahan andReiss)


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Chapter 5 - Competitors and Competition