1 competitors and competition besanko, dranove, shanley, and schaefer chapters 6

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Competitors and Competition

Besanko, Dranove, Shanley, and SchaeferChapters 6

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Agenda Competitor Identification Measuring Market Structure Market Structure and Competition

Perfect Competition Monopoly Monopolistic Competition Oligopoly

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Competitor Identification One way of identifying competitors

is to examine the cross-price elasticity of demand. yx = (∂Qy/Qy) / (∂Px/Px) yx = (Qy/Qy) / (Px/Px) If this is positive, then the goods are

considered substitutes.

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Direct vs. Indirect Competitor A direct competitor is one whose

strategic choices directly affect the other company.

An indirect competitor is one who affects your company through the strategic choices of a third company.

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Conditions For Being Close Substitutes Competing products have the

same or similar product performance characteristics.

Competing products have the same or similar occasions for use.

Competing products are sold in the same geographic market.

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Differing Geographic Market Conditions Products are said to be in different

geographic markets if they are: Sold in different locations. Costly for either the producer or

consumer to transport the goods.

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Market Definition It identifies the market(s) in which

the firm compete(s). Two firms are said to exist in the

same market if they constrain each other’s ability to raise price.

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Measuring Market Structure Market structure is the number and

distribution of companies in a market. The concentration level of the

companies in your market can have a direct effect on your pricing strategy.

Two measures: N-Firm Concentration Ratio The Herfindahl Index

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N-Firm Concentration Ratio The N-Firm Concentration Ratio

gives the combined market share of the N largest firms.

A problem with this measure is that it does not take into consideration the proportions of each of the N largest companies. Hence a shift of market share from one

large firm to another goes unnoticed.

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The Herfindahl Index The Herfindahl Index (HFI) is defined as

the summation of the squared market shares of all firms in the market. HFI = i (Si)2 = S1

2 + S22 + … + SN

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Where Si is the market share for firm i. This index will account for changes in

market share between companies. The reciprocal of the HFI is known as the

numbers-equivalent of firms, which in essence tells you how many firms the market appears to have.

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Market Structure and Competition Market competition is usually

broken up into the following four general areas: Perfect Competition Monopoly Monopolistic Competition Oligopoly

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Market Structure and Herfindahl Index Perfect and Monopolistic

Competition tend to be seen in industries with a HFI index less than 0.2.

Oligopolies usually have a HFI between 0.2 and 0.6.

Monopolies tend to have HFI equal to 0.6.

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Perfect Competition Perfect Competition is said to exist if the

following conditions hold: Homogeneous products No barriers to entry or exit Large number of buyers and sellers Perfect information No collusion between the sellers or buyers No externalities (Perloff, Microeconomics) Transaction costs are low (Perloff, Microeconomics)

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Homogeneous Product A homogeneous product is a good

that has a perfect substitute, i.e., it does not matter who produced the good because the good appears to be the same no matter who produced it. E.g., #2 Yellow Corn, clothes pin

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No Barriers to Entry or Exit No barriers to entry or exit implies

that anyone can enter or exit the market without substantial cost. Farming can be perceived as having

an ever increasing barrier to entry which is the high cost to acquire the land.

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Large Number of Sellers The key to this condition for

competition is that no particular seller has the ability to affect the market because of her decisions.

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Perfect Information There must exist for all

participants information regarding prices, quantities, qualities, etc. With the internet and the idea of

precision farming, all the sectors in the economy are moving closer to this condition.

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No Collusion Collusion occurs when people get

together as a group and make decisions that affect the market. E.g., OPEC, stores that run ads

regarding price matching

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No Externalities An externality “occurs when a

person’s well-being or a firm’s production capability is directly affected by the actions of other consumers or firms rather than indirectly through changes in prices.” (Perloff, Microeconomics) E.g., Odor from a farm, pesticide drift

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Low Transaction Costs “Transaction costs are the

expenses of finding a trading partner and making a trade for a good or service other than the price paid for that good or service.” (Perloff, Microeconomics) E.g., having two sellers a great

distance apart.

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Competitive Firms Competitive firms tend to operate

where price is equal to marginal cost implying that there PCM is at zero.

They are always in fierce pricing competition with other firms in their market.

Competitive firms are usually not able to set prices, they take prices as given.

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Monopoly A monopoly exists if there is little

competition in its output market or input market. Monopolist relates to output markets. Monopsonist relates to input markets.

A monopoly does not have to be the only firm in a market. The key is that other firms cannot

sufficiently affect it through there actions.

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Monopoly Cont. Monopolies have the ability to

affect price through there output decisions.

Being a monopoly does not necessarily mean that you can charge monopoly prices. It depends on the level of potential

competition.

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Monopoly Cont. Monopolies also have varying levels

of price discriminatory power. If the monopoly cannot distinguish

between buyers, it must use the market demand curve to set one price.

A perfectly discriminatory monopoly would charge each buyer there marginal gain for each output level.

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A Monopoly Problem Suppose a monopoly existed in the emu

industry. Currently the firm that sells emu has a

variable cost of $10 for each emu and is facing a demand curve for their product of P(Q) = 100 – 2*Q.

What is the optimal amount of emus to produce and what is the optimal price.

Assume there are no fixed costs.

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Monopoly Solution The goal is to maximize profits (). = Total Revenue – Total Cost = P(Q)*Q – VC*Q = (100-2Q)*Q – 10*Q = (100*Q-2Q2) – 10*Q ∂/∂Q = 90 - 4Q = 0 This implies optimal output occurs at

22.5 and optimal price equals 55.

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Monopolistic Competition Monopolistic competition is

characterized by having most of the same conditions as perfect competition, where the only difference is that the products are viewed by the consumer to have slightly different characteristics, i.e., the products are differentiated.

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Differentiation in Monopolistic Competition Vertical Differentiation

When a product has characteristics that make it unambiguously better or worse than a competing product.

Horizontal Differentiation When a product has characteristics

that some consumers prefer over a competing product.

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Differentiation in Monopolistic Competition Cont. Even if two products are

homogenous, they still could be differentiated by geographic location.

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Geographic Differentiation Example Suppose you have two sellers of

ice cream where their products have the same physical characteristics.

Seller A is located at the north end of town, and seller B is located at the south end of time.

Suppose these two sellers are 10 miles apart.

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Geographic Differentiation Example Cont. Assume that there are three

customer bases in the city. Customer base 1 is located 4 miles

from seller A and 5 miles from seller B. Customer base 2 is located 5 miles

from seller A and 5 miles from seller B. Customer base 3 is located 6 miles

from seller A and 4 miles from seller B.

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Geographic Differentiation Example Cont. If it costs $1 per mile to travel,

which store would each consumer base go to? What would happen if seller B

lowered his price by $0.50? What would you need to know to

know if seller B is better off?

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Oligopoly Oligopoly markets are characterized by

a few large producers controlling most of the market.

The action of just one company can have an effect on the industry price.

There are generally two types of competition considered with oligopolies: Cournot Quantity Competition Bertrand Price Competition

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Cournot Quantity Competition In this type of competition, each

firm chooses how much output it will produce.

After quantity has been chosen, they consider what price to charge to clear the market.

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Cournot Quantity Competition Cournot competition is characterized

by each firm developing a best response to what it thinks its rival will do.

It does this by developing a reaction function. A reaction function is a response

function to what you believe your competitor is going to do.

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Cournot Equilibrium A Cournot Equilibrium is the outputs and

market price that satisfy the following two conditions: The equilibrium price is the price that clears

the market given the firms’ production levels. The equilibrium quantity of each firm is the

best response to the equilibrium quantity chosen by the other firms.

Best response means that there is no better choice given your competitors strategy.

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Cournot Equilibrium Example Suppose there are only two firms in the

market using the same technology and has the same costs.

Suppose the market demand is the following: P = 100 – Q

Where Q is the total quantity in the market.

Also assume that the cost for each unit produced by each firm is $10 per unit of output.

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Cournot Equilibrium Example Cont. What is the Cournot Equilibrium

price and quantity for each firm? Answer will be worked out in class.

Note: Cournot Competition does not maximize industry profits.

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Bertrand Price Competition Unlike the Cournot Model, the

Bertrand price model has the firm choosing price rather than quantity.

Due to this price competition, price is pushed down to marginal cost. The key to obtaining this solution is that

the products are perfect substitutes.

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Bertrand Versus Cournot The Cournot model considers a two

stage decision process where output is first chosen and then price is considered, while the Bertrand model assumes that price is set and each firm then sets quantity.

The Bertrand model is related more to industries that have flexible production capacity.