AEC 422 Announcements



Diamond Foods Case Discussion and preliminary
memo – Sept 29 (next Mon.)
Diamond Foods final memo due Wed Oct 1
– One comprehensive analysis submitted per group
Preliminary and final memos should follow case
analysis format, but especially emphasize key
concepts from Unit 1.
Unit 1
Microeconomics of the Firm
Competitors and Competition
AEC 422
Sept 22
Industry

An industry is a collection of firms offering
goods or services that are close substitutes
of each other. (V. Jain, 2007)

North American Industry Classification
System (NAICS) replacing the Standard
Industrial Class (SIC) codes.
Industry Definitions
NAICS
Code
NAICS Description
Classification Level
31-33
Manufacturing
Sector
312
Beverage and tobacco product
manufacturing
Subsector
3121
Beverage manufacturing
Industry group
31211
Soft drink and ice manufacturing
Industry
312111
Soft drink manufacturing
National Industry
For detailed codes: http://www.census.gov/naics/2007/naics07.xls
Other Empirical Approaches
–
–
–
–
Bureau of Labor Statistics Market Classes
BLS NAICS Aggregation Titles
http://www.bls.gov/bls/naics_aggregation.htm
Products that belong to the same genre or the
same NAICS class need not be substitutes
Organization of industry



Driven by economics shaping firm size,
scope, bounds, and vertical relationships
Substitutes and complements
Clusters – shared resources (tourism, port,
university technology park); manufacturing
and distribution relationships
Competition




If one firm’s strategic choice adversely affects the
performance of another they are competitors
In practice anyone who produces a substitute
product is a competitor
Competition can be either direct (between soft
drinks) or indirect (soft drinks and milk)
Important implications for product development,
advertising, pricing
Taco Bell: Who is my competition?
Taco Bell: Who is my competition?

Other Mexican restaurants
–


Other Mexican fast food
Other fast food restaurants
–
–
–
–


Abuelos?
Burgers
Pizza
Chicken
Italian
In-store Mexican RTE meals
Convenience stores &
supermarket deli’s



“healthy” fast food?
Fine(r) dining restaurants?
How do we define “market
share”?....depends how we
define the market (later)
Characteristics of Substitutes

Two products tend to be close substitutes
when
–
They have similar performance characteristics

–
They have similar occasion for use and

–
Kroger brand mustard vs French’s Mustard
Breakfast cereal vs Pop Tarts
They are sold in the same (geographic) market
area

Various brands of gasoline in an area
Performance Characteristics

Empirical Approaches to Competitor Identification

Cross price elasticity of demand

Eab = (∆Qa/Qa)/
(∆ Pb/Pb)
Substitutes, complements, or independent

–


If Eab > 1….then A and B are substitutes (Pepsi & Coke)
If Eab < 1…then A and B are complements (hot dogs & buns)


Price for turkey increases what will happen to the quantity
demanded for turkey dressing around Thanksgiving?
Price of gas increases, quantity of cars demanded decreases
–


Eab < 0
Price for pizza (fast food substitutes) increases, quantity
demanded for Mexican fast food increases
Price for UK tuition increases, quantity demand for BCTC
classes increases
–

Complements:
Substitutes:
Eab > 0
Larger the magnitude of the cross-price elasticity, the
more pronounced the effect.
Occasion for Use




Products may share characteristics but may differ in
the way they are used
Orange juice and cola are beverages but (generally)
used in different occasions
What about milk?
Other examples – similar product – different use:
– Hiking shoes versus court shoes
– Desktop vs laptop computer vs iPad
Whole and 1% Milk Consumption
Lb/capita in U.S.
Whole Milk
1% Milk
Market (Geographic) Area

Identical products in two different geographic
markets may not be substitutes due to
“transportation costs”
–
–

Lawn care or construction services
Banks?? Education?? Library?
Bulky products like cement cannot be
transported over long distances to benefit
from geographic price difference
Geographic Competitor
Identification


When a firm sells in different geographical
areas, it is important to be able identify the
competitor in each area
Rather than rely on geographical
demarcations, the firm should look at the flow
of goods and services across geographic
regions
Two Step Approach to Identifying
Competitors in the Area



First step is to find out where the customers
come from (the catchment area)
The second step is to find out where the
customers from the catchment area shop
With the technological innovations, some
products like books and drugs are sold over
the internet bringing in virtual competitors
–
Amazon.com
Market Structure



Markets are often described by the degree
of concentration
Monopoly is one extreme with the highest
concentration - one seller
Perfect competition is the other extreme with
innumerable sellers
Measuring Market Structure

A common measure of concentration is the N-firm
concentration ratio - combined market share of the
largest N firms (or brands)
–



Ice Cream Brands Example
Edys, Breyers, Blue Bell, Haagen-Dazs, and Ben &
Jerry’s make up 51.1% of the Ice Cream market
share in the U.S.
Dean Foods, Kraft Foods, and Land O’ Lakes made
up 37.5% of the dairy processing sales in the U.S. in
2005
Also measured as 4-firm CR or 20-firm CR
Industry
Number of firms
Bookstores
Computer & software
Casino Hotels
Full service restaurants
Florists
Besanko et al, p.210, 5th Ed
12751
10133
283
195492
22753
4-firm CR
20-firm CR
62
51
44
9
2
70
65
76
16
4
Measuring Market Structure

Herfindahl index is another which measures
concentration as the sum of squared market
shares
–

Sum of the squared market shares of all the firms
in the market
Ie a market divided between 2 firms would
be:
–
0.52 + 0.52 = 0.5
Four Classes of Market Structure
Structure
Perfect
Competition
Monopolistic
Competition
Oligopoly
Monopoly
Herfindahl Index
Usually < 0.2
Intensity of Price Competition
Fierce
Usually < 0.2
Depends on the degree of
product differentiation
Depends on inter-firm rivalry
Light unless there is threat of
entry
0.2 to 0.6
> 0.6
Dairy Products, U.S., 2007
Source: The Food Institute
Market Structure and Competition

A monopoly market may produce the same
outcomes as a competitive market (threat of entry)
–


Think of the one ice cream shop in a growing town
A market with as few as two firms can lead to fierce
competition
With monopolistic competition, how well
differentiated the products are will determine the
intensity of price competition
Perfect Competition



Many sellers who sell a homogenous product
and many well informed buyers (transparent
market)
Consumers can costlessly shop around and
sellers can enter and exit costlessly
Each firm faces infinitely elastic demand
–
Smallest hike in prices pushes them out of the
market
Conditions for Fierce Price
Competition

Even if the ideal conditions are not present,
price competition can be fierce when two or
more of the following conditions are met
–
–
–
There are many sellers
Customers perceive the product to be
homogenous
There is excess capacity
Vertical and Horizontal Differentiation

Vertically differentiated products unambiguously
differ in quality (USDA grade#1 tomatoes vs #2s)
–


Bourbon? Wine?
Horizontally differentiated products vary
in certain product characteristics to appeal to
different consumer groups (cage free eggs, FSC)
An important source of horizontal differentiation is
geographical location – taking same products to
different geographic markets
Geography and Horizontal Differentiation

Video rental outlets (or grocery stores) attract
clientele based on their location
–


Move to movie downloads?
Consumers choose the store based on
“transportation costs”
Transportation costs prevent switching
for small differences in price
Idiosyncratic Preferences

Tastes differ substantially across consumers
–



Food products, beverages, entertainment, apparel
Horizontal differentiation possible with
idiosyncratic preferences
Easier to segment the market
Location and Taste are important sources of
idiosyncratic preferences
Willingness-to-pay across selected
demographic variables
Blueberry
Vinegar
Blueberry
Syrup
N
196
243
Variable (t-ratio)
Constant
Male
Age
Income
Education
Health Knowledge
2.0791 (4.13)***
0.1994 (1.14)
-1.1639 (-2.33)**
0.0580 (2.75)***
0.7587 (2.31)**
0.0917 (0.40)
2.3174 (5.83)***
0.2196 (1.68)*
-1.0765 (-2.76)***
0.0445 (2.46) **
0.6447 (2.38)**
0.4646 (2.63)***
R2
0.12
0.12
Statistically significant at the 90% (*), 95%(**), or 99%(***) confidence level.
Search Costs and Differentiation




Search cost: Cost of finding information
about alternatives
Search costs discourage switching when
prices are raised
Low cost sellers try to lower the search costs
(Advertising, distribution)
Some markets have high search costs
(Example: ie. highly regulated products –
medical care)
Switching Costs and Monopolistic
Competition


An important determinant of a firm’s demand
is customer switching
Switching is less likely when
–
Customer preferences are idiosyncratic

–
–
Dentists, hairstylists, favorite restaurant
Customers are not well informed about alternative
sources of supply
Customers face high transportation or search
costs (what has the Internet done to this lately?)
Price-Cost Margins and
Concentration


Theory would predict that price-cost margins
will be higher in industries with greater
concentration (fewer sellers)
There could be other reasons for interindustry variation in price-cost margins
(regulation, accounting practices,
concentration of buyers and so on)
Price-Cost Margins and
Concentration


It is important to control for these extraneous
factors if one needs to study the relation
between concentration and price-cost margin
Most studies focus on specific industries and
compare geographically distinct markets
Evidence on Concentration and
Price




For several industries, prices are found to be
higher in markets with fewer sellers
See MacDonald’s 1999 ERS article
Lysine, infant formula, western railroads,
cattle slaughter
See Hendrickson & Heffernan
Economies of Scale and
Concentration



Industries with large minimum efficient scales
compared to the size of the market tend to
have high concentration
The inter-industry pattern of concentration is
replicated across countries
When production/marketing enjoys
economies of scale, entry is difficult and
hence profits are high
Concentration and Profitability


The concentration and profitability have not
been shown to have a strong relationship
Possible explanations
–
–
Differences in accounting practices may hide the
differences in profitability
When the number of sellers is small it may be due
to inherently unprofitable nature of the business