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Economics of StrategySixth Edition
Copyright 2013 John Wiley Sons, Inc.
Chapter 5
Competitors and Competition
Besanko, Dranove, Shanley, and Schaefer
Competition
If one firm’s strategic choice adversely affects the performance of another they are competitors
A firm may have competitors in several input markets and output markets at the same time
Competition can be either direct or indirect
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
Identifying Competitors
DOJ Guideline: Merger with all the competitors should lead to a small but significant non-transitory increase in price (SSNIP)
Small: At east 5% Non-transitory: At least for one year
Identifying Competitors
In practice any one who produces a substitute 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
Performance Characteristics
Performance characteristics describe what the product does to the customer
Example from automobiles Seating capacity Curb appeal Power and handling Reliability
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: Hiking shoes versus court shoes
Empirical Approaches to Competitor Identification
Cross price elasticity of demand Pattern of price changes over time
Firms in the same Standard Industrial Classification (SIC)
Standard Industrial Classification (SIC)
Products and services are identified by a seven digit code
Each digit represents a finer degree of classification
Products that belong to the same genre or the same SIC need not be substitutes
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
Identifying Competitors in the Area
Step 1: Locate the catchment area. (where the customers come from)
Step 2: Find out where the residents of the catchment area shop
With some products like books and drugs being sold over the internet identifying geographic competition becomes more difficult
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
Measures of Market Structure
The N-firm concentration ratio (the combined market share of the largest N firms)
Herfindahl index (the sum of squared market shares)
When the relative size of the largest firms is important Herfindahl is likely to be more informative
Four Classes of Market Structure
Nature of Competition
Range of Herfindahls
Intensity of Price Competition
Perfect Competition
Usually < 0.2 Fierce
Monopolistic Competition
Usually < 0.2 Depends on the degree of product differentiation
Oligopoly 0.2 to 0.6 Depends on inter-firm rivalry
Monopoly > 0.6 Light unless there is threat of entry
Perfect Competition
Many sellers who sell a homogenous good
Many well informed buyersConsumers can costlessly shop
around Sellers can enter and exit costlesslyEach firm faces infinitely elastic
demand
Zero Profit Condition
With perfect competition economic profits go to zero
When profits are maximized percentage contribution margin or PCM = 1/ where is the elasticity of demand
In perfect competition is infinity and hence PCM = 0
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
Many Sellers
Even when the industry is profitable, a low cost producer may prefer to set a low price
With many sellers, cartels and collusive agreements harder to create and sustain
Small players will be tempted to cheat and small cheaters may go undetected
Homogeneous Products
Three sources of increased revenue when price is lowered Customers buying more New customers buying Customers switching from the competitors
Excess Capacity
When a firm is operating below full capacity it can price below average cost to cover 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
Monopoly
A monopolist faces little or no competition in the output market
Monopolist can act in an unconstrained way in setting prices or quality, subject to demand
If some fringe firms exist, their decisions do not materially affect the monopolist’s profits
Monopoly
A monopolist faces a downward sloping demand curve
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
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
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
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
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
Geography and Horizontal Differentiation
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
Idiosyncratic Preferences
Horizontal differentiation is possible with idiosyncratic preferences
Location and Taste are important sources of idiosyncratic preferences
Search costs discourage switching when prices are raised
Search Costs and Differentiation
Search cost: Cost of finding information about alternatives
Low cost sellers try lower the search costs (Example: Advertising)
Some markets have high search costs (Example: Physicians)
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
Monopolistic Competition and Entry
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
Monopolistic Competition and Entry
Customer loyalty allows prices to exceed marginal 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 by customers, then entry cannot be considered excessive
Oligopoly
Market has a small number of sellersPricing 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
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)
Cournot Duopoly: An Illustration
Both firms have constant marginal cost of $10
Demand curve: P = 100 – Q1 – Q2
Firm 1 chooses Q1 to maximize profits taking Q2 as given
Reaction function: Q1 = 45 – 0.5Q2
Firm 2’s problem is a mirror image of Firm 1’s
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
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
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
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
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
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
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
Market Structure: Causes
Theory would predict that the larger the minimum efficient scale (MES) of production the greater will be the concentration.
If entry is not easy concentration will be the result
Monopolistic competition would mean easier entry and larger number of firms
Endogenous Sunk Costs
Consumer goods markets seem to have a few large firms and many small firms
The number of large firms and the total number of firms depend more on advertising costs than production costs (Sutton)
Advertising costs are endogenous sunk costs
Endogenous Sunk Costs
Early in the industry’s life cycle many small firms 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
Price-Cost Margins & Concentration
Theory would predict that price-cost margins will be higher in industries with greater concentration
There could be other reasons for variation in price-cost margins Regulation Accounting practices Concentration of buyers
Price-Cost Margins & Concentration
It is important to control for these extraneous factors to study the relation between concentration and price-cost margin
Most studies focus on specific industries and compare geographically distinct markets
Evidence on Concentration and Price
For several industries, prices are found to be higher in markets with higher concentration
For locally provided services (doctors, plumbers etc.) the “entry threshold” – population needed to support a given number of sellers – increases fourfold between 1 and 2 sellers
Evidence on Concentration and Price
En = entry threshold for n sellers
For locally provided services E2 is about four times E1
E3 - E2 > E2 – E1
E4 – E3 = E3 – E2
Intensity of price competition reaches the maximum with three sellers (Bresnahan and Reiss)
Copyright © 2013 John Wiley & Sons, Inc.
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