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Competitors and competition ~ industry and competitive analysis

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  • 1. Economics of Strategy Fifth Edition Besanko, Dranove, Shanley, and Schaefer Chapter 8Competitors and Competition Slides by: Richard Ponarul, California State University, Chico Copyright  2010 John Wiley  Sons, Inc.
  • 2. 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
  • 3. 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
  • 4. Identifying CompetitorsDOJ Guideline: Merger with all thecompetitors should lead to a small butsignificant non-transitory increase in price(SSNIP)  Small: At east 5%  Non-transitory: At least for one year
  • 5. 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
  • 6. Performance Characteristics Performance characteristics describe what the product does to the customer Example from automobiles  Seating capacity  Curb appeal  Power and handling  Reliability
  • 7. 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
  • 8. Geographic Area Identical products in two different geographic markets will not be substitutes due to “transportation costs” Bulky products like cement cannot be transported over long distances to benefit from geographic price difference
  • 9. Empirical Approaches to Competitor Identification Cross price elasticity of demand Pattern of price changes over time Firms in the same Standard Industrial Classification (SIC)
  • 10. Cross Price Elasticity Q y / Q y  yx  Px / PxIf ηyx is positive, consumerspurchase more of Y when theprice of X increases
  • 11. Patterns in Price Changes Prices of close competitors tend to be highly correlated Data on purchase patterns reveal how individual consumers react when sellers change their prices
  • 12. 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
  • 13. 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
  • 14. 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
  • 15. 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
  • 16. 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
  • 17. Four Classes of Market Structure Nature of Range of Intensity of Price Competition Herfindahls CompetitionPerfect Usually < 0.2 FierceCompetitionMonopolistic Usually < 0.2 Depends on the degreeCompetition of product differentiationOligopoly 0.2 to 0.6 Depends on inter-firm rivalryMonopoly > 0.6 Light unless there is threat of entry
  • 18. 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
  • 19. 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
  • 20. Conditions for Fierce Price CompetitionEven 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 be homogenous  There is excess capacity
  • 21. 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
  • 22. Homogeneous Products Three sources of increased revenue when price is lowered  Customers buying more  New customers buying  Customers switching from the competitors
  • 23. Homogenous Products For firms that cut prices, customers switching from a competitor are likely to be the largest source of revenue gain Customers will be less loyal to the sellers and sellers are more likely to compete on price
  • 24. 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
  • 25. Monopoly A monopolist faces little or no competition in the output market Monopolist can act in an unconstrained way in setting prices or quality If some fringe firms exist, their decisions do not materially affect the monopolist’s profits
  • 26. 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
  • 27. Monopoly and Output The traditional anti-trust view is that limited output and higher prices hurt the consumer. A competing (Demsetz) view is that consumers may benefit even at monopoly prices if the monopoly was the result of product innovations and efficient manufacturing.
  • 28. 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
  • 29. 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
  • 30. 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
  • 31. 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
  • 32. 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
  • 33. Horizontal DifferentiationFigure 8.1: Sandwich Retailers in Linesville
  • 34. 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
  • 35. 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)
  • 36. 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
  • 37. 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
  • 38. 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
  • 39. Oligopoly Market has a small number of sellers Pricing 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
  • 40. 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)
  • 41. 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
  • 42. Cournot Reaction Functions
  • 43. 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
  • 44. 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
  • 45. 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
  • 46. Bertrand Reaction Functions
  • 47. 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
  • 48. 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
  • 49. 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
  • 50. 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
  • 51. 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
  • 52. 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
  • 53. 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
  • 54. 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
  • 55. 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
  • 56. 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
  • 57. 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)
  • 58. Copyright © 2010 John Wiley & Sons, Inc.All rights reserved. Reproduction or translation of this work beyondthat permitted in section 117 of the1976 United States Copyright Actwithout express permission from the copyright owner is unlawful.Requests for further information should be addressed to thePermissions Department, John Wiley & Sons, Inc. The purchaser maymake back-up copies for his/her own use only and not for distributionor resale. The Publisher assumes no responsibility for errors,omissions, or damages caused by the use of these programs or fromthe use of the information herein.