Chapter 5: Competitors and Competition

Characteristics of substitutes

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

Measuring market structure

-A common measure of concentration is the N-firm concentration ratio - combined market share of the largest N firms. -Herfindahl index is another which measures concentration as the sum of squared market shares.

Monopoly

-A monopolist faces little or no competition in the product market -Monopolist can act in an unconstrained way in setting prices -If some fringe firms exist, their decisions do not materially affect the monopolist's profits

Monopoly and output

-A 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 -The traditional anti-trust view is that limited output and higher prices hurt the consumer

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 -In practice anyone who produces a substitute product is a competitor

2-step approach to identifying competitors in the area

-First step is to find out where the customers come from (the catchment area) -The second step is to find out where the customers from the catchment area shop -With the technological innovations, some products like books and drugs are sold over the internet bringing in virtual competitors

Evidence on concentration and price

-For several industries, prices are found to be higher in markets with fewer sellers -In markets where the top three gasoline retailers had sixty percent share prices were 5 percent higher compared to markets where the top three had a fifty percent share -For service providers such as doctors and physicians, three sellers were enough to create intense price competition

Market structure: oligopoly

-Herfindahl index: 0.2 to 0.6 -Intensity of price competition: depends on inter-firm rivalry

Market structure: monopoly

-Herfindahl index: > 0.6 -Intensity of price competition: light unless there is threat of entry

Market structure: monopolistic competition

-Herfindahl index: usually < 0.2 -Intensity of price competition: depends on the degree of product differentiation

Market structure: perfect competition

-Herfindahl index: usually < 0.2 -Intensity of price competition: fierce

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

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

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

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 -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 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

Bertrand Duopoloy

-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

Cournot Oligopoly

-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)

Perfect competition

-Many sellers who sell a homogenous product and many well informed buyers -Consumers can costlessly shop around and sellers can enter and exit costlessly -Each firm faces infinitely elastic demand

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

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

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 -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 -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

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

Excess capacity

-When a firm is operating below full capacity it can price below average cost as price covers 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

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

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 -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

Many sellers

-With many sellers, cartels and collusive agreements harder to create -Cartels fail since some players will be tempted to cheat since small cheaters may go undetected -Even if the industry PCM is high, a low cost producer may prefer to set a low price

Zero profit condition

-With perfect competition economic profits go to zero -Percentage contribution margin PCM equals (P - MC)/P where P and MC are price and marginal cost respectively -When profits are maximized PCM = 1/n where n is the elasticity of demand -Since n is infinity, PCM = 0

Switching costs and monopolistic competition

An important determinant of a firm's demand is customer switching Switching is less likely when: -Customer preferences are idiosyncratic -Customers are not well informed about alternative sources of supply -Customers face high transportation costs

Performance characteristics

Empirical Approaches to Competitor Identification: -Cross price elasticity of demand -Pattern of price changes over time -Product characteristics -Products that belong to the same genre or the same SIC need not be substitutes

Conditions for fierce 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

Indirect competitors

Strategic choice of one firm affects the performance of the other because of a strategic reaction by a third firm

Direct competitors

Strategic choice of one firm directly affects the performance of the other

Concentration and profitability

The concentration and profitability have not been shown to have a strong relationship Possible explanations: -Differences in accounting practices may hide the differences in profitability -When the number of sellers is small it may be due to inherently unprofitable nature of the business

Homogeneous products

Three sources of increased revenue when price is lowered: -Customers buying more -New customers buying -Customers switching from the competitors -With many sellers collusive agreements are harder to sustain -For firms that cut prices, customers switching from a competitor are likely to be the largest source of revenue gain -Customers are more likely to price shop when the product is perceived to be homogenous and hence sellers are more likely to compete on price