Competitor Identification/ Mkt Definition
• Prerequisite for analyzing competition:
- identifying your competitors
- defining your market
Competitor Identification
• Identifying competitors by identifying
substitutes
• Substitutes are products whose crossprice elasticities of demand are positive
• There is a distinction between direct and
indirect competitors
• Similar products in different geographic
markets may not be substitutes
Discussion question
What do you think is the Antitrust approach
to market definition?
Market Definition
• Market definition describes the market in
which a firm competes
• Two firms are in the same market if they
constrain each others ability to raise price
• Suppose all firms collectively set prices to
maximize combined profits. Would they
choose to raise prices by a least 5%?
Market definition
• If the own-price elasticity of a group of
firms collectively is small, then this group
of firms constitutes a well-defined market
• Antitrust agencies (Dept of Justice) looks
at the above
Market Structure and Competition
• Market structure refers to the number and
distribution of firms in a market
• Common measures are N-firm
concentration ratio and Herfindahl index
• The Herfindahl index of an industry
depends on the nature of competition in
the industry
A typology of competition
• Perfect competition:
- many sellers
- homogenous products
-well-informed consumers can
costlessly shop around
A typology of competition
• Monopoly:
-no competition for output
• Monopolistic competition:
-many sellers
-each sells a differentiated product
• Oligopoly:
-few sellers, so the actions of one firm
materially affects the others
Discussion question
What is more important: the attractiveness
of an industry, or the position of a firm in
an industry?
Industry attractiveness vs
firm position
• Firm position is more important
• What explains variation in firm profitability?
Source of variation
% variation
explained
Business-specific effects
32
Industry
19
Corporate parent
4
Year
2
• The remaining unexplained percentage is random error
A Tool for Assessing Industry
Attractiveness: Porter’s Five
Forces
Threat of new
entrants
Bargaining
power
of suppliers
Rivalry among
existing industry
firms
Threat of substitute
products
Bargaining
power
of buyers
Performing the 5-forces analysis
• Assess each force by asking “Is it
sufficiently strong to reduce/eliminate
industry profits?”
• Internal rivalry
-begin by defining market
-price competition drives down prices
-non price competition drives up costs
-industry prices do not fall by themselves, so
you ask “Who will reduce it and why?”
Forces that drive down prices
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Many sellers
Stagnant or declining industry
Firms have different costs
Excess capacity
Undifferentiated products
Large/infrequent sales orders
Strong exit barriers
Prices/terms of sale unobservable
Prices cannot be adjusted quickly
Threat of new entrants
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Entry is pervasive.
Consider industry with 100 firms in 2005
Between 2005-2010, 40 new firms will enter
30-40% turnover of firms, with 12-20% of volume
Entrants/exiters are smaller than estb. firms
Most entrants do not survive 10yrs
Entry and exit vary by industry, and are highly
correlated
Barriers to entry
• Structural
-control of essential resources
-economies of scale or scope
-marketing advantages of incumbency
• Strategic
Strategic barriers to entry
• First analyze entry conditions and choose
entry-deterring strategy
• Entry conditions can be
-Blockaded
-Accommodated entry
-Deterred entry
Entry deterring strategies
• Limit pricing
-charge a low price before entry occurs
• Predatory pricing
-charge a low price after entry occurs
• Capacity expansion
Limit pricing
• Incumbent sets a low price
• Entrant infers that post-entry price would be low
as well
• And so will not enter
• Is the potential entrant’s inference about postentry pricing rational?
Limit pricing
• Uncertainty about incumbent’s post entry
price might rescue limit pricing
• Uncertainty may be about
-Incumbent’s objectives
-Incumbent’s costs
-Level of market demand
• Does limit pricing really occur?
Predatory pricing
• Predatory firm sets a low price to drive (existing)
competitors out of the market
• It then recovers any losses from the low price by being a
monopolist
• It appears that predatory pricing is irrational in any finiteperiod interaction
•
Yet, firms still do it
• Role of uncertainty and incumbent’s reputation for
toughness in understanding paradox
Capacity expansion
• Do ‘large’ or ‘small’ firms have higher
incentives to do it?
• Is it motivated just by efficiency, or by
strategic desire to gain pricing-power
through preemption?
Supplier power/buyer power
• Upstream suppliers have power if
-they are concentrated
-customers have relationship specific investments
-buyers do not buy large volumes
-they can forward-integrate easily
-they can price-discriminate
• Buyer power is just flip side of the above