Lecture 3: MARKET STRUCTURE AND
PRODUCT DIFFERENTIATION
AEM 4160: Strategic Pricing
Prof. Jura Liaukonyte
1
Lecture Plan
1
Other
Elasticities




2
Market
Concentration




3
Product
Differentiation
4
Price
Discrimination



Income Elasticity
Cross Price Elasticity
Price Elasticity of Supply
What does it mean
How to measure
Why do we care?
HHI, CR4-Ratio, Lerner Index
Differentiation and market structure
Implications for pricing
First Degree PD
Second Degree PD
Poll Everywhere

At the beginning of each lecture you will be presented with a keyword.


To sign-in for the day, text:


Today’s keyword is BACKPACK
Keyword netID to 37607

don’t forget the space between the keyword and netID
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Keyword is not case sensitive.
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For today:
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BACKPACK jl2545
Go online to:
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or
jl2545
Other Demand Elasticities

Income Elasticity of Demand

Measures how much quantity demanded changes with a change
in income
EI 
 Q/Q
 I/I

I Q
Q I
Values for Income Elasticity (EI)

Sign indicates normal or inferior.



EI >0 implies normal good.
EI <0 implies inferior good.
Normal goods may be necessity or luxury.
Other Demand Elasticities

Cross-Price Elasticity of Demand

Measures the percentage change in the quantity
demanded of one good that results from a one percent
change in the price of another good
E Q b Pm 
Qb Qb
 Pm Pm

Pm  Q b
Q b  Pm
Other Demand Elasticities

Complements: Cars and Tires

Cross-price elasticity of demand is negative


Price of cars increases, quantity demanded of tires decreases
Substitutes: Butter and Margarine

Cross-price elasticity of demand is positive

Price of butter increases, quantity of margarine demanded increases
Illustration: Cross Price Elasticity
Two Complements
Price of Product X
Price of Product A
Two Substitutes
Demand for Product B
Demand for Product Y
Size of shift in Demand
Assume Psubst Increases
EXY>1
Price
Price
EXY<1
D
D’
Demand for Product
D D’
Demand for Product
Example: The Cross-Price Elasticity of
Demand for Cars
Sentra Escort LS400 735i
Sentra -6.528 0.454

0.000
0.000
Escort 0.078
-6.031 0.001
0.000
LS400 0.000
0.001
-3.085 0.032
735i
0.001
0.093
0.000
-3.515
Source: Berry, Levinsohn and Pakes, "Automobile Price in
Market Equilibrium," Econometrica 63 (July 1995), 841-890.
Price Elasticity of Supply
Definition

Measures the sensitivity of
quantity supplied given a change
in price
 Measures the percentage
change in quantity supplied
resulting from a 1 percent
change in price
Formula
E
S
P

% Q S
% P
Profit Maximization: MR=MC
Set Up
 profit(q)
 How
Optimization
= TR(q) – TC(q)
to maximize profit?
Profit Maximization: MR=MC
 profit(q)
Set Up
Optimization
= TR(q) – TC(q)

Profit maximization: dprofit/dq = 0

This implies dTR(q)/dq - dTC(q)/dq = 0

But dTR(q)/dq = marginal revenue


dTC(q)/dq = marginal cost
So profit maximization implies MR = MC
Profit Maximization: Monopoly Condition
Derivation of the monopolist’s marginal revenue
$/unit
1. Demand: P = A – B*Q
2. Total Revenue: TR = P*Q = A*Q – B*Q2
3. Marginal Revenue: MR = dTR/dQ
4. MR= A-2B*Q
A
Demand
With linear demand the marginal
revenue curve is also linear with
the same price intercept
…
but twice the slope
Quantity
MR
2
Market Concentration
Different Market
Structures
Measurements of
market structures

Numbers and size distributions of firms


1.
2.
3.
Ready-to-eat breakfast cereals: high concentration
Newspapers: low concentration
Concentration ratio,
Herfindahl-Hirschman Index (HHI)
Lerner Index (LI)
Industry Concentration

Four-Firm Concentration Ratio

The sum of the market shares of the top four firms in the defined
industry. Letting Si denote sales for firm i and ST denote total industry
sales
C 4  w1  w 2  w 3  w 4 , where w1 

Si
ST
Herfindahl-Hirschman Index (HHI)

The sum of the squared market shares of firms in a given industry,
multiplied by 10,000: HHI = 10,000  S wi2, where wi = Si/ST.
HHI
The Herfindahl-Hirschman Index – the square of the percentage
market share of each firm summed over the largest 50 firms in the
industry (or all of the firms if there is less than 50)

Definition
Properties

In perfect competition, the HHI is small

In monopoly, the HHI is 10,000 (100 squared)

A popular measure with the Justice Dept in the 1980’s

Example

HHI < 1000 characterized competitive markets

HHI > 1800 would bring Justice Dept challenge to proposed
mergers
E.g. The cigarette industry is highly concentrated with only 8 firms
and a Herfindahl-Hirschman Index (HHI) of 2623
Measure of concentration
Firm Rank
Squared Market
Share
1
25
625
2
25
625
3
25
625
4
5
25
5
5
25
6
5
25
7
5
25
8
5
25
Concentration Index
18
Market Share
(%)
Measure of concentration
Market Share
(%)
Firm Rank
1
2
3
4
5
6
7
8
Concentration Index
19
Σ
25
25
25
5
5
5
5
5
CR4 = 80
Squared Market
Share
Σ
625
625
625
25
25
25
25
25
H = 2,000
Measure of concentration
Market Share
(%)
Firm Rank
1
2
3
4
5
6
7
8
Assume firms 4
and 5 merge
Concentration Index
20
25
25
25
5
5
5
5
5
Squared Market
Share
625
625
625
25
25
25
25
25
Measure of concentration
Market Share
(%)
Firm Rank
1
2
3
4
5
6
7
8
Σ
Assume firms 4
and 5 merge
Concentration Index
21
25
25
25
5
5
5
5
5
10
Squared Market
Share
Σ
625
625
625
25
25
25
25
25
100
Measure of concentration
Market Share
(%)
Firm Rank
1
2
3
4
5
6
7
8
Σ
The concentration
indices change
Concentration Index
22
25
25
25
5
5
5
5
5
10
CR4 = 80 85
Squared Market
Share
Σ
625
625
625
25
25
25
25
25
100
H = 2,000 2050
Example: Candy and Chocolate
Industry
Candy v. Chocolate
CANDY
1.00%
Mars Incorporated
HHI (for top 4) = 1141
CR ₄ = 59%
Medium level concentration
->Concentration is increasing
The Hershey Company
1.00%
2.00%
Tootsie Roll Industries
2.00%
2.50%
13.40%
3.00%
4.00%
49.50%
21.60%
Ferrara Pan Candy
Company
1,039 businesses overall!
Jelly Belly Candy
Company
Russell Stover Candies Inc.
Kraft Foods
CHOCOLATE
Nestle Inc.
HHI (for top 4)= 2941.81
Cr ₄ = 78.1%
High level of concentration
Mars Incorporated
The Topps Company
Other
The Hershey Company
25.00%
39.00%
Russel Stover
20.00%
10.00%
518 Businesses overall!
0.50%
0.50%
Nestle
Lindt & Sprungli
Guittard Chocolate
Company
See's Candies
4.00%
1.00%
Other
CR₄ and HHI: Candy Industry



The HHI for just the top 4 companies in the industry is
2941.81.
The CR ₄ for the industry is 78.1%.
Therefore, the industry is highly concentrated with only a
few major firms holding a majority of the market share.
CR ₄ = 49.5 + 21.6 + 4 + 3= 78.1%
*Hershey and Mars Inc. alone hold 71.1% of the market share.
-Note that students calculated HHI incorrectly (need to add
squared market shares for top 50 companies, not only top 4)
Example: Credit Card
Industry
Market Definition

All Credit Lending Institutions with their own card








27.2%
19.2%
18.9%
17.2%
4.0%
J.P. Morgan Chase & Co.
Bank of America Corporation
Citigroup Inc.
American Express Company
Capital One
CR4: 83.2
HHI: 1810-1850
Total Number of Companies: 192
MARKET SHARE
J.P. Morgan Chase
Bank of America Corporation
Citigroup Inc.
American Express Company
Capital One
5%
20%
31%
22%
22%
What is a Market?

No clear consensus
 the market for automobiles


the market for soft drinks

what are the competitors for Coca Cola and Pepsi?
With whom do McDonalds and Burger King compete?
Presumably define a market by closeness in substitutability of the
commodities involved
 how close is close?
 how homogeneous do commodities have to be?


should we include light trucks; pick-ups SUVs?
Fast-Food Outlets
McDonald’s
Burger
King
Wendy’s
Market Performance


Market structure is often a guide to market performance
But this is not a perfect measure


Can have near competitive prices even with “few” firms
Measure market performance using the Lerner Index
LI =
P-MC
P
Lerner Index

Lerner Index:
L = (p - MC)/p = 1/|EP|



The higher the number, the more pricing power the firm has.
Mark-up power reflects monopoly power.
PUNCHLINE: If elasticity increases, mark-up will
decline. If the product becomes less elastic, markup will increase.
What are Sources of Monopoly Power?
• Low elasticity of demand
• We just showed this using Lerner Index.
• Possibly due to strong product differentiation.
• High barriers to entry
• e.g., ownership of necessary raw materials, patents and regulatory
barriers, scale economies, product diff.
• Number of other competitors in market.
• Interactions between firms: Compete or cooperate?
Product Differentiation

Products are different if there is some objective characteristic
or property, real or perceived, that provides a basis for buyers
to choose one over the other.

Product differentiation may lead to reduced own -price
elasticity. As the degree of differentiation increases, the price
elasticity will decrease.
Product Differentiation, cont.

Ways in which products are differentiated.
 Product Brand
 Packaging
 Conditions of Sale
 Service Provided
 Location

Product Differentiation as an Entry Strategy
 Product differentiation to create a niche market.
 Product differentiation to deter entry.
Product Positions in Characteristics Space