Market structure and competition

By A.V. Vedpuriswar

Competitors and Competition

A given firm may compete in several input and output markets simultaneously. It is important to analyse each market separately.

Two firms directly compete if a price increase by one causes many of its customers to do business with the other.
When firms are direct competitors, the strategic choices of one directly affect the performance of the other.

Products tend to be close substitutes when three conditions hold:

Same or similar product performance characteristics. Same or similar occasions for use. Sold in the same geographic market.

The degree to which products substitute each other is measured by the cross price elasticity of demand.

Cross price elasticity = percentage change in demand for good Y that results from 1% change in the price of X

Market Structure
Market structure refers to the number and distribution of firms in a market. We can measure this in many ways. N firm concentration ratio = largest Herfindahl index the Combined market share of the N firms in the market.

= Sum of the squared market shares of all firms in the market

Problem

The following are the approximate market shares: Coke 40%, Pepsi 30%, 7 Up 10%, Dr Pepper 10% All other brands 10% Calculate the Herfindahl index

Herfindahl index

= (.4)**2 + (.3)**2 + (.10)**2 + (.10)**2 + (.10)**2

=.16 + .09 + .01 + .01 + .01

=0.28

What would happen if Pepsi took over 7 Up?

Herfindahl index

=(.4)**2 + (.4)**2 + (.10)**2 + (.10)**2

= 0.34

Different forms of market structure

Perfect competition There are many sellers and well informed buyers.

Profit is maximised when Price = Marginal cost.

Monopoly
A firm is a monopolist if it faces little or no competition.
-

- A monopolist faces a downward sloping demand curve. - A monopolist selects the price such that marginal revenue equals marginal cost. - A monopolist can set the price without regard to how other firms will respond.

The monopoly solution (Cont)

price, marginal revenue, marginal cost, average total cost

Marginal cost
Average total cost

G Marginal

Demand

revenue Quantity per period

Monopolistic competition
-

There are many sellers Each seller sells a differentiated product

- A product is vertically differentiated when it is unambiguously better or worse than competing products
- A product is horizontally differentiated when only some consumers prefer it to competing products. - Horizontal differentiation results when consumers have idiosyncratic preferences.

Location can be a source of preferences

-

idiosyncratic

Tastes can be a source of idiosyncratic preferences

- The degree of horizontal differentiation depends on the magnitude of search costs, i.e., how easy or hard it is for customers to get information about alternatives.

Monopolistic competition (short run)

MC

ATC
P C

Economic profit

D MR
Q

Oligopoly

A market in which the actions of individual firms materially affect the industry price level is called Oligopoly. Each firm has to take into account the strategies of other firms even as it frames its strategy.

Game theory is useful here.

Game theory :Prisoners dilemma payoff matrix

3 years

10 years

Both admit
3 years 1 year

One denies
other admits

One denies, other admits

1 year

2 years

Both deny
10 year

2 years

Game Theory
Consider two firms, Alpha and Beta. Each firm must decide whether to increase production capacity in the coming year. The consequences of the firms actions are summarised below. Beta Do Not expand Do not expand $18, $18 Alpha Expand $ 20, $15 $ 16, $ 16 Expand $ 15, $ 20

Game Theory (Cont..)

Consider pay off for Alpha

If Beta expands and Alpha expands, and Alpha does not expand, If Beta does not expand and Alpha expands, and Alpha does not expand, profit = $20 profit = $18 profit = $16 profit= $ 15

So it makes sense for Alpha to expand in both cases. See previous slide

Game Theory (Cont..)

Consider pay off for Beta

Say Alpha expands

Beta does not expand

Beta expands

profit = $15
profit = $16

Say Alpha does not expand Beta does not expand Beta expands profit = $18 profit = $20

So it makes sense for Beta to expand in both cases See earlier slide

So the Nash equilibrium is that each firm expands its capacity.

At the Nash equilibrium, each player is doing the best it can, given the strategies of other players.

If each party expects the other to choose its Nash equilibrium strategy, then in fact both parties will choose their Nash equilibrium strategies

The Nash equilibrium does not necessarily correspond to the outcome that maximises the aggregate profit of the players.

Beta

Do Not Expand

Small

Large

Do Not Expand 18, 18

15, 20

9, 18 Beta

Alpha

Small

20, 15

16, 16

8, 12

Large

18, 9

12, 8

0, 0

Equilibrium point is Small, Small Alpha

Game Tree for Sequential Capacity Expansion Game

Do not expand Beta Do Not Expand Small Large Do not expand Beta Small Small ($15,$20) ($9,$18) ($18,$18)

Alpha

($20,$15)

($16,$16)

Large ($8,$12) Do not expand Beta Large Small Large ($0,$0)

($18,$9)

($12,$8)

If both firms decide simultaneously, the equilibrium is (Small, Small)

What happens if Alpha first decides?

In a sequential move game, Alphas capacity choice has commitment value. It forces Beta into a corner. By committing to a large capacity expansion, Alpha forces Beta into a position where Betas response yields the outcome that is most favourable to alpha. So Alpha makes a large expansion while Beta does not expand. The payoff is (18,9)

Cournot Model
-

Consider only two firms in the market.

- They produce identical goods and charge the same prices. - The sole strategic choice is the total amount they produce, Q1 + Q2 - The market price is that which enables both firms to sell all their output. - Each firms optimal level of production is the best response to the level it expects its rivals to choose.

-This model applies to situations where firms must make production decisions in advance and are committed to selling all their output.
-This may be so if bulk of the production costs are sunk or it is costly to hold inventory.

Cournot Equilibrium
Suppose there are two players in the market.

For A,

TC1 = 10 Q1

For B,

TC2 = 10 Q2

Marginal cost = ? Market demand is given by Q1+Q2 = 100 P or P = 100 (Q1+Q2) At Cournot equilibrium, P1* = 100 Q1* - Q2*
(Q 1*

, Q2* are market clearing output)

Q1* is As profit maximising output given that it guesses B will produce Q2 * Q2* is Bs profit maximising output given that it guesses A will produce Q1*

Assume that A guesses B will produce Q2g Then As profit = Revenues - Total cost = P1 Q1 - 10 Q1 = (100 Q1-Q2g) Q1 10 Q1 = 100 Q1 Q12 Q2g Q1 10 Q1 Profit = 90 Q1 Q12 Q2g Q1 We differentiate and equate to zero to find out maxima/minima. d (profit) / d Q1 = 90 2Q1 Q2g d 2(profit) / dQ12 = -2Q1 = always - ve So it is a maxima point

90 2Q1 Q2g = 0
2Q1 = 90 - Q2g Q1 = 45 - .5 Q2g

So if A expects B to increase its output, it will reduce the output and vice versa. Similarly profit maximising value of Q2 = 45 - .5 Q1g So Q1 = 45 - .5Q2g Q2 = 45 - .5 Q1g At equilibrium, Q2g = 45 - .5 (45 - .5Q2g Q2g = 45 22.5 + .25 Q2g 0.75 Q2g = 22.5 Q2g = 22.5 /.75 = 30 Q1g = 45 - .5 (30) = 30 So at equilibrium, Q1* = Q2* = 30
)

Process of adjustment in Carnot equilibrium ( Q2 = 45 -0.5*Q1) Q2 ,Q1 are both 40

Starting Q1
40 25 25 28.75 28.75

Starting Q2
40 40 32.5 32.5 30.63

Adjusting firm
1 2 1 2 1

Ending Q1
25 25 28.75 28.75 29.69

Ending Q2
40 32.5 32.5 30.63 30.63

Bertrand Model
-Each firm selects a price and stands ready to meet all the demand for its products at that price. -Each firm selects a price to maximise its own profits, given the price that it believes the other firm will select. -When the firms products are perfect substitutes, price competition will be severe.

-Rivalry between the two firms is enough to achieve the perfectly competitive outcome.
-The Bertrand model applies to markets in which capacity is sufficiently flexible so that firms can meet all the demand that arises at the prices they announce. -Firms expect all increases in sales will through business stealing. come

P = 100 (Q1 + Q2) Cournot equilibrium is P = 100 30 30 = 40

But this is not the Bertrand equilibrium.

If B charges 40, A may charge 39 and grab the entire market, i.e., Q1 = 100 P = 61 Profits for A in Cournot equilibrium = (40) (30) (10) (30) = 900 Profits for B now = (39) (61) (10) (61) = (29) (61) = 1769

As long as both firms set prices that exceed marginal costs, one firm will have an incentive to undercut the other and grab the entire market. The only possibly equilibrium is P1 = P2 = marginal cost = 10. In Bertrand model, rivalry between the two firms is enough to achieve the perfectly competitive outcome. Price competition will be fierce if the products are perfect substitutes. When products are differentiated, competition will be less intense.

Differences between Cournot and Bertrand model

Cournot competitors can be thought of as choosing capacities and then competing as price setters given the capacities chosen earlier. The Cournot model applies most naturally to markets when firms must make production decisions in advance and are committed to selling all of their output.

This might occur because the bulk of the production costs are sunk or because it is costly to hold inventory.
So prices will adjust more quickly than quantities. Each firm will try to keep sales equal to planned production volumes. Business stealing is not an option.

Bertrand model applies to markets in which capacity is sufficiently flexible.

Firms can meet all of the demand that arises at the prices they announce.

When products are substitutes, each firm believes it can steal business from its competitors through a small cut in price.

Firms expect all the increase in sales to come from business stealing.

Horizontally differentiated markets Undercutting will not lead to loss of entire business. Say Q1 = 63.42 - 3.08 P1 + 2.25 P2 Q2 = 49.52 5.48 P2 + 1.40 P1 As Marginal cost = 4.96

Bs Marginal cost

= 3.94

As profit = (P1 4.96) (63.42 3.98 P1 + 2.25 P2g) P1 = 10.44 + .2826 P2g = (P2g - 3.94) (49.52 5.48 P2 + 1.40 P1g) Bs profit

P2 = 6.40 + .1277 P1g Solving P1 = 12.72, P2 = 8.11

(4)

Consider a market with two horizontally differentiated firms, X and Y. Each has constant marginal cost of $20. Demand functions are: Qx = 100 2 Px + 1 Py Qy = 100 2 Py + 1 Px
Calculate the Bertrand equilibrium.
x

= (Px 20) (100 2 Px + Pyg)

= (Py 20) (100 2 Py + Pxg) d x 0 Differentiating with respect to P we get,

dx d y
dy 0

100 4Px + Pyg + 40 = 0

100 4Py + Pxg + 40 = 0

At equilibrium,

Px = Pxg ,

Py = Pyg

100 4Pxg+ Pyg + 40 = 0

100 4Pyg+ Pxg + 40 = 0

Or

400 16 Pyg+ 4Pxg + 160 = 0

Adding, we get
500 15 Pyg + 200 = 0

Pyg = 700/15, Pxg = 140 + 700/15 = 700/15