Chapter 6: Market StructureChapter 8: Competitive Strategy

Review Assignment 1Market structure archetypes• Defining your Market• Perfect competition • Monopoly

Competitive Strategy• Creating Value• Capturing Value• Porter’s Five ForcesDel Monte Fresh PineappleWalmart, p. 221.

Defining your market• The boundaries of an economic market should

include all the firms & their products that interact to determine prices

• Analyze each of your markets separately• Can use both qualitative & quantitative

methods for identifying competitors (i.e. substitutes)

• Geography may be important

Defining your marketQualitative approach

• Product performance characteristics– Red roof inn, Motel 6

• Occasions for use

– Coke and bottled water

• Geographic market

– Local; national; global

Defining your marketQuantitative criteria

• Demand elasticities– Price elasticity

• higher => look for lots of competitors

– Cross-price elasticity• Strongly positive => close substitutes

• Price correlations– Airfares moving together

• SIC codes may help– U.S. Census Bureau conducts Economic Census every 5 years (92, 97,02)– Firms are categorized according to type of product or service provided– In each category: # firms, sales, payroll, employees– http://factfinder.census.gov/

• Example of SIC codes– 311 Food mfctg

• 3112 Grain & oilseed milling– 31121 Flour milling & malt manufacturing

» 31123 Breakfast cereal manufacturing• Your market may not fit in neatly

Market Structure

• Defined by attributes of the market environment– Number & concentration of the participating firms

– Characteristics of the product(s) they sell

• Affects behavior of participating firms

Concentration– As the degree of concentration increases, it may be

possible for firms to gain pricing advantage (but not necessarily)

– A measure of concentration is useful in describing the nature of a market

Market structureconcentration measures

• Concentration ratios (97 Economic Census)% of sales of the top n firms in each NAICS code

• Herfindahl-Hirschman index (HHI)– 10,000 x The sum of squares of each firm’s

fraction of industry sales– Monopoly HHI = 10,000– Merger guidelines

• < 1000 unconcentrated• 1000 < HHI < 1800 moderately concentrated• > 1800 concentrated

Definitions of Market Structures

Product Type/ Information

# of sellers / entry barriers

Behavior

Perfect Competition

Homogeneous/

Good info about price and quality

Many /

low

Very competitive low prices

Monopolistic Competition

Differentiated Many/

Relatively low

Relatively low

Can be quite competitive - price, brand, quality, etc.

Oligopoly Homogeneous or differentiated

Few; or a few large firms with fringe of small firms

/moderately high

Strategic interaction

Competition can vary depending on situtation

Monopoly Absence of close substitutes

One/

Very high

Cushy position, high prices

May strategize to keep barriers high

Monopoly – “Mono” “opoly”

• Strong barriers to entry single seller• Product has no close substitutes• Price “maker” (“searcher”)• E.g. Prilosec by Astra-Merck in 1996• Gasoline on Toll Roads

Barriers to entry

• Specific assets

• Economies of scale

• Excess capacity

• Reputation effects

• Pre-commitment contracts

• Licenses and patents

• Learning-curve effects

• Pioneering brand advantages

Optimal Single-price Pricing• Pricing objective – maximize total profit• MR = MC for optimal output

=> Optimal markup formula

at optimal output Q*Application: The elasticity of demand for gasoline on the New

Jersey toll road = 10.What markup would a profit maximizing firm use???

1

1

MCP

MCMCMCP

%11.19.

1

1011

1

Derivation of Optimal Markup Rule From Profit Maximization: MR = MC Working with MR side:TR / Q = MC (defn of MR) (P Q + Q P) / Q = MC (breakdown of TR) P + Q( P / Q) = MC (a little algebra) Here comes elasticity:* P - Q[(1 / )(P / Q)] = MCP[1 - (1 / )] = MC (Factor out P; cancel Q’s)  Optimal markup rule:P = MC / [1 - (1 / )] (Divide by [ ] term)___________________________________________________*Need equation (1) for the elasticity step above:Defn. of elasticity = (-1)(Q/Q) / (P/P) Multiply by reciprocal = (-1)( Q/Q)(P/P)Rearrange = (-1)( P /Q) ( Q /P)Solve for (-1) ( P /Q) P /Q = (-1)(1 / ) (P / Q)

Monopoly: Markup and Profits

QM

D

P

MR

PM

Q

MC

ACA

BAverage Cost of Producing

Each Unit

Markup

Perfect competitioncharacteristics

• Many buyers and sellers• Low seller concentration (each firm has low market

share)• Homogeneous product• Low cost and accurate information about product and

price• Price “taker”• Free entry and exit• E.g. commodity markets; agricultural products

Entry and pricingperfect competition

• Above normal profitAttracts entry Increases market supplyReduces market priceReduces unit profit (P vs. ATC)

• Below normal profitPromotes ExitDecreases market supply Increases market priceOver time, increases unit profit (P vs. ATC)

Perfect Competition: Long run Pricing After entry/exit

MR = MC → firms use equimarginal thinkingP = min LRAC → so efficient production

Normal Profit = 0 economic profit

Monopoly Versus Perfect Competition

P

Q

PM

QM

A

MC

MR

Consumer Surplus

Deadweight Social Loss

Producer Surplus

(a) Monopoly

D

P

P1

QQ1

MC

Consumer Surplus

(b) Perfect Competition

D

Producer Surplus

Application:• Pick a market/industry with which you are

familiar. Based on your text reading, how would you describe its market structure and why? How narrowly/broadly are you defining the market (e.g. does Coke compete in all beverages or bottled soft drinks)? How would you characterize barriers to entry to this market?

Strategy• General policies intended to generate profits

– Choice of industry– Combination of products and services– Competitive and cooperative behaviors

• Strategies evolve as circumstances change

• Strategies must create and capture value

Creating Value for ConsumersA firm has market power if…

...it faces a downsloping demand curve.

The firm’s pricing objective is……to maximize shareholder value.

The demand curve reflects……consumer willingness and ability to buy.

Consumer surplus = consumers’ gains from trade

Ways to create valueDel Monte Gold: A sweet example??

Market Structure and Capturing Value

• Firms in competitive markets are price takers

• Market power and superior resources can lead to economic profit

• Going for the Gold and Pineapple Acid Test, WSJ– What are/were the barriers to entry into the

premium pineapple market? – What is/will be the market structure of the

premium pineapple market? Profitability?

Example: Pineapple value

• $5 reservation price

• $1.50 cost

• 1 pineapple

$3.50 value created

• willingness to pay or reservation price – Demand strategy

• Cost – Low cost strategy

• Q – Demand strategy

Value created

Example: Pineapple valuecontinued…

If purchased at $3

Consumer surplus = $2.00

Producer surplus = $1.50

So firm only captures $1.50 of $3.50 value created…

• $5 reservation price

• $1.50 cost

• 1 pineapple

$3.50 value created

Porter’s five forces

• Potential rivals• Existing rivalry• Substitute products• Buyer power• Supplier power

Let’s go to the video tape

Superior factors of production

• People– special talents or skills

• Physical assets– prime real estate– unique equipment

• But bidding for specialized assets may erode profits

Producer surplus captured by superior assets

Superior factors of production

• Team production– interdependencies among workers increase value

beyond the “sum of the parts”– luck or foresight may endow firms with unique

team production capabilities

• Rivals may be unable to pinpoint source of advantage and unable to capture equivalent value

Wal-Mart, p. 221• What is the impact of Wal-Mart.com on customer-

borne transaction costs?• Do you think that Wal-Mart.com is likely to create

additional value?• Is it likely that Wal-Mart will capture any value

created by Wal-Mart.com?• Should Wal-Mart have pursued e-commerce more

aggressively sooner?• What do you think the potential impact of Wal-

Mart.com will be on the company’s efforts to expand internationally?

Looking Forward• Assignment 2

– Due on October 14,18 or 19

• Read – Managerial Economics

• Chapter 7 – Pricing

– Coursepack• The Power of Smart Pricing

• The Usual Decorous Waltz…

• The Myth of Market Share

• Blackboard– Why are Hotel Minibars So Expensive?” - Glenn Ellison