Economics of Strategy

Fifth Edition
Slides by: Richard Ponarul, California State University, Chico
Copyright 2010 John Wiley Sons, Inc.
Chapter 8

Competitors and Competition
Besanko, Dranove, Shanley, and Schaefer
Competition
If one firms 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
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
Empirical Approaches to Competitor Identification

Cross price elasticity of demand
Pattern of price changes over time
Firms in the same Standard Industrial
Classification (SIC)

Cross Price Elasticity
x x
y y
yx
P P
Q Q
/
/

If
yx
is positive, consumers
purchase more of Y when the
price of X increases
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

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 buyers
Consumers can costlessly shop around
Sellers can enter and exit costlessly
Each 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
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
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
If some fringe firms exist, their decisions do
not materially affect the monopolists profits
Monopoly
A monopolist faces a downward sloping
demand curve
Monopolist sets the price so that marginal
revenue equals marginal cost
Thus the monopolists price is above the
marginal cost and its output below the
competitive level


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.
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 monopolists 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 firms
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
Horizontal Differentiation
Figure 8.1: Sandwich Retailers in Linesville
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 firms 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 firms 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 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 others moves
Cournot Duopoly
In the Cournot model each of the two firms
pick the quantities Q
1
and Q
2
to be produced
Each firm takes the other firms 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 Q
1
Q
2
Firm 1 chooses Q
1
to maximize profits taking
Q
2
as given
Reaction function: Q
1
= 45 0.5Q
2
Firm 2s problem is a mirror image of Firm
1s


Cournot Reaction Functions
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 Reaction Functions
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 industrys 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
E
n
= entry threshold for n sellers
For locally provided services E
2
is about four
times E
1

E
3
- E
2
> E
2
E
1
E
4
E
3
= E
3
E
2
Intensity of price competition reaches the
maximum with three sellers (Bresnahan and
Reiss)
Copyright 2010 John Wiley & Sons, Inc.

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