Economics of Strategy Sixth Edition Copyright 2013 John Wiley Sons, Inc. Chapter 5 Competitors and Competition Besanko, Dranove, Shanley, and Schaefer.

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)

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