Market Structure and
Strategic Competition
Chapter 6
Key Concepts
Defining the Market

Ideal market definition should take into account the possibilities
for substitution

If substitution across goods/services is easy, these
goods/services should be considered one market


Production dimension
Geographical dimension

Substitution versus new entry

Substitution on the production side should be included only if
the existing capacity can be shifted in the short run to produce
those substitutes
Concentration Ratio

A fundamental problem with concentration ratios is they only
discuss one point in the distribution of firms’ market shares

Depending on the number of firms, concentration ratios can be
contradictory
Concentration: an Example
Herfindahl and Hirschman Index

HHI is defined as the sum of the squared market shares of all
firms in the industry

In that way HHI includes information on all firms in the industry

HHI can be thought of as the average slope of the
concentration curve in the industry (steeper slopemore
concentration)

HHI maximum is attained at 10000 (a single producer)

Regulation authorities use the threshold of 1000 as critical
Concentration Curves: an
Example
Concentration of Selected Industries
HHI and Policy

Empirical evidence has demonstrated
the positive association of high HHI
values with high price-cost margins

Why do we have this positive
relationship?
Collusion hypothesis
 Differential efficiency hypothesis

Minimum Efficient Scale

To achieve low unit costs, some firms need to engage in largescale production

When efficient production scale (reached in the long run at the
minimum of the average cost curve) is comparable to the
market, there is only room for a few large firms in that industry

Specialization is usually cited as a major reason for firms to gain
from large-scale production

However, empirical research has found most firms operate at
larger scales compared to the minimum efficient scale

Is there any room for collusion here?
Minimum Efficient Scale
Entry Conditions

The number of active firms is
determined by the ease of entry
Cost factor
 Economies of scale


Entry conditions determine the extent of
potential competition
Free Entry

Remember the present value of an infinite stream of benefits of
equal nominal size for interest rate r is equal to the reciprocal of
r (B/r, the taxi driver license example)

Suppose a firm’s profit in each year depends on the number of
firms in a decreasing fashion

We can then identify the amount of firms in the industry given
the entry costs

When entry costs increase, the equilibrium amount of firms
under free entry decreases
Effect of the Cost of Entry on
Equilibrium Number of Firms
Barriers to Entry

Barriers to entry are difficult to define


Are patents barriers to entry?
Will welfare increase if patent rights will be waived?

One definition of an entry barrier says: a barrier to entry may be
defined as a cost of producing which must be borne by firms
seeking to enter an industry but is not borne by firms already in
the industry

The socially oriented definition says: socially undesirable
limitations to entry of resources which are due to protection of
resource owners already in the market
Scale Economies as Barriers to Entry

Entry may result in too much output that can only be
sold at a price that is below average cost

Even if the new entrant produces a lower amount
compared to the efficient one, the unit costs will be
still too high for it making entry unprofitable in either
case

Undercutting the incumbent may not work since
consumers are normally loyal to the existing brands
and advertising increases the entrant’s costs again
Scale Economies as Barrier to Entry
Contestability and Sunk Costs

A market is perfectly contestable if three conditions are met



Potential entrants have no technological disadvantage with respect
to the incumbents
Zero sunk costs: all costs associated with entry are fully
recoverable
The entry lag is less than the price adjustment lag for incumbents

If market is perfectly contestable, the equilibrium should entail a
socially optimal outcome

Hit-and-run entry will result in the incumbent firm pricing at
average cost

In this way sunk costs are barriers to entry
Dominant Firm Theory

There is one big firm and a large number of small price-taking firms

The dominant firm first selects the price which the fringe takes as given

The dominant firm’s residual demand is the difference between market demand
and the fringe’s supply

At price P0, the fringe produces nothing so the dominant firm has all the market

The dominant firm prices at P* where its marginal revenue is equal to marginal
cost

The dominant firm’s residual demand is flatter than the market demand since
consumers can substitute away from the dominant firm towards the fringe

The outcome is, a price that is lower compared to the monopolistic case
Dominant Firm and
Competitive Fringe
Dynamic Pricing

We need to develop the dynamic versions of the
dominant firm model

The fringe’s ability to invest into more capacity grows
with:




Its retention ratio (from retained earnings)
The existing capacity
The price set by the dominant firm
For that reason, there is an additional pressure for
the incumbent to set lower current prices since
current prices set by dominant firm affect fringe’s
supply in the future
Myopic Pricing

Myopic pricing: set current price so as to
maximize current profit

Dominant firm’s price decreases

Capacity of the fringe grows

Reynolds Pen’s market share went down to almost
zero due to its high profit margins, but they made
a lot of profit nevertheless
Limit Pricing

Limit pricing: set the price so as to prevent all
fringe expansion

Prevents the fringe from investing into additional
capacity

Results in lower current profits, but higher profits
in the future

Depending on the discount rate, myopic pricing
can be preferable to limit pricing
Optimal Pricing

Optimal pricing

Start with the price above the limit pricing level but
below the one that maximizes the dominant firm’s
current profit

Dominant firm’s price will keep on converging to
the limit pricing level

The fringe grows to reach a certain level and then
stops there
Myopic, Limit and Optimal Pricing
Profits for Limit and Myopic Pricing
Strategic Competition

Re-cap: Structure-Conduct-Performance paradigm

We mentioned that firms’ behavior (conduct) can
affect the market structure



A dominant firm reduces price over time in order to constrain
the growth of the fringe
We now assume all firms in the market are large enough to
afford behaving strategically
Examples of strategic behavior


Predatory pricing
Strategic entry deterrence (subject of this section)
Bain-Sylos Model of Limit Pricing

Return to limit pricing, but assume no firm is
a price taker

Bain-Sylos postulate: the entrant believes
that, in response to entry, each incumbent
firm will continue to produce at its pre-entry
output rate

The entrant only receives the residual demand
that can be manipulated by the incumbent
Residual Demand under
Bain-Sylos Postulate
Deterring Entry

Initially all firms in the industry have the long-run average cost curve
AC

Output level by the incumbent equal to Qbar makes sure the residual
demand for the fringe leaves no possibility for making positive profits
Critique of Bain-Sylos Postulate

Keeping incumbent’s output at the same level
irrespectively of entry may not be necessarily the
incumbent’s profit-maximizing strategy

According to Cournot’s theory, an incumbent will
reduce its output with more entry

Entry decision is independent of pre-entry output
since the post-entry demand and cost functions are
independent of the pre-entry past output decisions
by the incumbent
Past and Present

Past output could affect current demand or costs:



Adjustment costs make it costly to change the level of output
The more a firm produces today, the higher its profitmaximizing output in the future
Post-entry profits for the new entrants are less since the
best-reply function of the incumbent firm shifts outward

An incumbent firm may then deter entry by producing
a sufficiently large level of output prior to potential
entry

Bain-Sylos assumption then obtains when we
assume infinitely large adjustment costs
Effect of Pre-Entry Output on Post-Entry Equilibrium
with Adjustment Costs