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ECONOMICS 3200MLecture 7

Ch. 7, 8, 11

March 2, 2016

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Monopolistic Competition• 2-stage game• Each consumer purchases 0 or 1 unit of product• Consumers have following preferences:

– U = V* - total cost of product– If U(0) > U(1) > 0 or U(0) > 0 > U(1), then buys product at 0– If U(1) > U(0) > 0 or U(1) > 0 > U(0), then buys product at 1– If 0 > U, buys neither

• Distribution of consumers by preferred location (X): F(X)– F(0) = 0– F(1) = 1– Critical value of X: consumers indifferent between two varieties

• V* - [P0 + TX] = V* - [P1 + T(1-X)] > 0• X^ = [P1 – P2 – T]/2T

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Monopolistic CompetitionCase 1• Overlapping demand P1 – P0 < T

– D(0, P1, P0, T) = N[F(X^)]– D(1, P1, P0, T) = N[1-F(X^)]

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U

0 1

V* - P0

V* - P1V* - P0 – TX

V* - P1 – T(1-X)

X^

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Monopolistic CompetitionCase 2• Product at 0 has entire demand – importance of cost advantage P1 – P0 > T

– D(0, P1, P0, T) = N for P0 P1 - T– D(1, P1, P0, T) = 0

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Monopolistic CompetitionCase 3• Separate monopolies at 0 and 1 – demand curves do not overlap• P0 , P1 [V* - T, V*] P0 + P1 + T > 2V*

– D(0, P1, P0, T) = N[F(X0)] where X0 = (V* - P0)/T– D(1, P1, P0, T) = N[1-F(X1 )] where X1 = (T - V* - P1)/T > X0

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X0 X1

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Monopolistic CompetitionCircular model• Consumers distributed uniformly along circumference of circle• No tendency for two firms to locate in same location

– Product differentiation• Consider case where there are no barriers to entry

– Assumptions:• Consumers distributed uniformly along circumference of circle• Length of perimeter (circumference) = 1• “Travel” occurs along circumference (not along line between two points)• Linear transportation costs (T per unit)• Firms can locate at only point• Identical unit costs (C)• Fixed entry cost (Z: sunk cost)• Location of firms exogenously determined to allow for maximal differentiation

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Monopolistic CompetitionCircular model• Consider case where there are no barriers to entry

– Solution: i = 0 (because of entry)• N (number of firms, brands) = T/Z• Pi = C + TZ• P > C even though = 0• P increases as Z, T increase• N increases as Z decreases, T increases (P – C) decreases

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Monopolistic CompetitionCircular model• Alternative outcome: brand proliferation by incumbent – crowd

product space to block entry– Entry deterrence greater for brand proliferation if there are economies of

scope, fixed costs– Block distribution channels – preferred locations in supermarkets

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Structure-Conduct-Performance• Performance of firms (profits, prices) in industry depends upon

conduct of buyers and sellers which in turn depends on structure of market – Porter’s five forces

• Competitive strategies to gain competitive advantage in order to generate superior financial performance

• Execution of strategies as important as developing strategies

• Market structure also influences rates of return

• Key determinants of market structure – industry competitors – degree of rivalry; bargaining power of suppliers; bargaining power of buyers; closeness of substitutes

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Structure-Conduct-Performance

• Measures of performance – profitability– Price-cost margin: /PQ = 1/– Rate of return on assets: /(D+E) =

(/PQ)*[PQ/(D+E)]– Rate of return on equity: /E = [/(D+E)]*[(D+E)/E]

• Leverage and ROE• Covenants

– Does performance determine structure? – successful/lucky firms dominate

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Structure-Conduct-Performance• Rivalry

– Intensity and nature of rivalry • Pricing, marketing, distribution, innovation

– Number of firms• Cooperation, competition

– Switching costs for customers (training, compatibility of different networks)

– Concentration and balance of competitors (market shares of largest firms in industry)

– Government policy (competition law, trade laws, regulation)– Macroeconomic environment and cyclical sensitivity of industry

• Overcapacity – manufacturing vs. services– Globalization – new competitors, no history– Entry and exit barriers

• Threat of entry– Informational complexity

• Complexity encourages imitation

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Structure-Conduct-Performance• Threat of entry

– Entry barriers – cost advantages of incumbents (economies of scale, learning curve, proprietary technology, bargaining power); differentiation advantages of incumbents (brand identity, ability to continually develop new products)

– Other entry barriers – switching costs, capital requirements, information requirements (technology, customer needs, prices of inputs, etc.), access to distribution channels, absolute cost advantages

– Sunk costs– Scope and timing of entry– Expected retaliation by incumbents – government policy

(competition law)– Other government policies – trade laws, foreign ownership

restrictions

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Structure-Conduct-Performance

• Bargaining power of suppliers– 1 vs. 2 rule – monopoly power of suppliers

• Multiple suppliers – airlines want both Airbus and Boeing to survive

– Internalization vs. outsourcing• Outsourcing: multiple suppliers

– Switching costs – concessions offered by suppliers– Costs of inputs as % of total costs– Threat/credibility of forward integration relative to

backward integration– Supplier concentration – sole sourcing– Impact of inputs on costs or differentiation

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Structure-Conduct-Performance• Bargaining power of buyers

– Bargaining leverage• Buyer concentration vs. supplier concentration – monopsony, bilateral

monopoly• Buyer volumes• Buyer information• Ability to integrate backward – internalization• Substitute products

– Price sensitivity• Product differences• Brand identity• Impact on quality/performance/costs• Decision makers’ incentives• B2B, B2C (e.g. Trip Advisor, Yelp, Rotten Tomatoes)

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Structure-Conduct-Performance• Global Markets and Consolidation

– Impact on market structure – new rivals; different competitive advantages; lack of previous market contact (uncertainty re. competitive responses)

– Impact on set of feasible competitive strategies – Entry into new markets – de novo entry (greenfield investment)

vs. acquisition of incumbents– Consolidation – economies of scale; globalization of brand names

(leveraging brand names in number of markets); cooperation among rivals; defensive strategies; diversification; incentive contracts for senior management

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Strategic Behavior• Set of actions a firm takes to influence market environment (structure

and conduct) and increase profits (performance)– Not static as in structure-conduct-performance paradigm– Economic rents motivate firms/agents– Market environment – factors that impact performance: intensity of

rivalry, threat of entry, bargaining power of buyers/suppliers, substitutes

• Cooperative strategic behavior– Coordinate actions with rivals to limit intensity of rivalry– Not necessarily across all strategic variables (instruments)

• Non-cooperative strategic behavior– Develop/implement competitive strategies to gain/maintain competitive

position relative to rivals to enhance performance– Affect conduct (including inducing cooperative behavior with respect to

subset of instruments), change structure to improve performance

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Strategic Behavior

• Strategies depend upon history of company, core competencies of company, possible competitor reactions (market structure within which company competes)– Success of strategies in creating, extending competitive

advantage depends upon skills, abilities of senior management; execution of strategies (organization structure, incentives/motivation); luck (timing, bad decisions by competitors, right location, macroeconomic environment)

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Strategic Behavior• Competitive strategies

• Be cheaper• Be better – continued focus on quality• Be different – continued focus on product innovation.

• Cost, differentiation, niche• Cost leadership cannot ignore differentiation• Differentiation cannot ignore costs• Niche cannot ignore costs and differentiation

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Strategic Behavior• Cost leadership

– Timing: first mover advantages– Economies of scale/scope– Learning– Technology – development, adoption– Human resource management– Internalization vs. external transactions– Procurement, logistics – supply chain management– Production scheduling – inventories, maintenance, capacity utilization– Geographic location– Bargaining leverage– Mix and variety of products, product configuration/performance/features

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Strategic Behavior• Cost leadership

– Risks– Cost leadership not sustainable – competitors can imitate

quickly, technology developed externally, globalization (new competitors, sources of supply of inputs)

– Proximity in differentiation lost – cannot ignore basis for differentiation

– Cost focusers achieve lower costs in selected segments

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Strategic Behavior

• Basis for success in differentiation– Quality and motivation of employees – human resource

management– Quality, reliability, performance, design– Broad product line– Service, including credit (availability of financing)– Delivery, logistics (speed, costs) – Amazon and

delivery by drones– Adaptability – Advertising, marketing, sales force – big Pharma– Distribution channels – consider mutual funds, designer

labels, autos, Apple

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Strategic Behavior• Differentiation

– Buyer value – lower costs, enhanced performance for products• Buyer perception of value• Signaling criteria – reputation, image, packaging, appearance of facilities, time

in business, market share, parent company identity, customer list– Risks

• Differentiation not sustained – competitors imitate, basis for differentiation becomes less important for buyers

• Cost proximity lost – cannot ignore costs• Differentiation focusers achieve greater (more valuable) differentiation in

select segments• Too much differentiation – uniqueness not valuable, too large a price premium

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Strategic Behavior• Focus/niche – differentiation/costs in select market

segments– Lululemon – Yoga

• Niche strategy and long tails– Actual percentage of market served by any competitor?– Risks:

• Focus strategy easily imitated• Target segment becomes structurally unattractive – demand declines,

entry• Broadly-targeted competitors overwhelm segment – segment’s

differences from other segments narrows, advantages of broad line increases

• New focusers sub-segment the market• Lower cost focusers enter the market

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Strategic BehaviorDefensive strategies • Sacrifice short-term profits to enhance longer-term sustainability of

competitive position – maintain monopoly power, economic rents • Raise structural barriers

– Spatial preemption – fill product gaps• Broaden product line to close off possible niches for entry• Introduce fighting or blocking brands to foreclose entry opportunities without

undermining position of principal brand and its reputation– Block access to distribution channels – exclusive agreements, broaden

product line to offer channel full line (transactions costs for distributor in negotiating with multiple suppliers), after-sales service, cooperative marketing

– Switching costs – free training for buyers’ employees, joint product development with buyer, establishing ties to buyer through B2B technologies

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Strategic BehaviorDefensive strategies • Raise structural barriers

– Increase capital requirements for entry – provide financing for buyers, warranty coverage

– Increased advertising budgets, data mining, shorter model life cycles– Foreclose alternative technologies – license rights to patents, joint

ventures in developing new technologies– Tie up suppliers – exclusive and/or long-term contracts, backward vertical

integration – Raise competitors’ costs

• Government regulations – environment, product safety, trade policies, tax• Increase labor costs – different production technologies (relative importance of

labor costs)• Switching costs that result in incompatibilities

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Strategic BehaviorDefensive strategies • Increasing expected retaliation – tactics that indicate firm intends to

defend position and create conditions making it inevitable that firm will retaliate– Firm’s reputation for retaliation influenced by history – response to past

challengers– Signal commitment to defend – announce intentions to defend market

share backed up by investment in capacity– Introduce fighting brands (multi-markets. Multi-brands)– Price guarantees to customers – match the competition, most favored

nation – Predatory strategies – pricing, capacity, brands, litigation (patent

infringement)