Economics of Strategy
Market Structures
and
Dynamic Competition
Substitutes and Cross-Price
Elasticity
• “In general, two products X and Y are
substitutes if, when the price of X increases
and the price of Y stays the same, purchases
of X go down and purchases of Y go up.”
• Individuals substitute continually
• Economists measure this relationship with
the “cross-price elasticity”
Cross-Price Elasticity
% change in the quantities of Y
Ecp
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% change in the price of X
How are the quantities sold in the market
for automobiles affected by changes in the
relative price of trucks?
Products tend to be close substitutes
when we observe…
• same or similar product performance
characteristics
• same or similar occasions for use
• same geographic market
Product performance characteristics
• subjective analysis of “similar” products so
definition of the market becomes debatable
• to reduce subjectivity, list the attributes which you
believe are most influential in the consumers
purchase decision
• Difficult to say to what degree they are substitutes
– Use cross-price elasticities
• Role of transactions and transportation costs?
Occasions for use
• Where is the product used?
• When is the product used?
• How is the product used?
Where? Geographic Market
• Is the product sold by competitors where
customers
– are not affected by transportation costs
• costs of time for the consumer to travel to an alternative
location to purchase
• costs of shipping the product to the customers location
– are not affected by tax differences
– convenience is not a major factor
When is the product used?
• Different demands during different hours,
days, weeks, months, seasons
– Golf Course prices in SW Florida
– Phone services
– Hotel/Motel accommodations
How is the product used?
• To listen to music…
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Radio
CD Player
Tape Player
Eight…. No don’t go there
MP3 Files
Napster
Problems in Identifying Substitutes
• identifying precise product performance
characteristics is subjective and imprecise
• does not answer “how good a substitute is it?”
– Use elasticity to solve this
• Transaction or transportation costs can be
influential
• convenience can be influential but the price
customers are willing to pay for it is subjective
Defining Markets
• “that set of suppliers and demanders whose
trading practices establishes the price of a good”
– George Stigler and Robert Sherwin
• Do the firms constrain one another’s ability
to affect price?
Defining the Market
• Market definition is the identification of the
market(s) in which the firm is a player
• Two firms are in the same market if they constrain
each other’s ability to raise the price
• It is important to define the market if market
shares need to be computed (for anti-trust
economics or business strategy formulation)
Well-Defined Market
• If the market is well defined, firms outside the
candidate market will not be able to constrain the
pricing behavior of those inside
• A thought experiment: If all the firms inside the
candidate market colluded, can they raise the price
by at least 5%? If they can, the market is well
defined
Coca Cola’s Market
• Is Coca Cola’s market, the market for cola drinks
or the market for all potable liquids (including tap
water)?
• In the face of anti-trust concerns, Coke would
have preferred the broader definition
• Judicial system found the carbonated drinks
market to be the relevant one
Firm Elasticity or Industry/Market
Elasticity?
• Clearly differentiate
– If I know the industry has a high cross-price
elasticity it means that if industry prices rise
people will substitute other products for my
industries’ good or service
– This tells us nothing about firm elasticity's
within the industry, which is what firms are
often interested in
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
Geographic Competitors
• First – Where do your customers come from
(define the “catchment” area)
• Second - Where do the customers in the catchment
area shop?
• With the technological innovations, the catchment
area widens
– Catalogue Sales
– Internet Sales
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
• Herfindahl index is another which measures
concentration as the sum of squared market
shares
• Entropy could be another measure of
concentration
– How fast do competitors disappear and appear?
Herfindahl Index
Structure
Perfect Competition
Monopolistic
Competition
Oligopoly
Monopoly
Herfindahl Index
Usually < 0.2
Usually < 0.2
0.2 to 0.6
> 0.6
Intensity of Price Competition
Fierce
Depends on the degree of product
differentiation
Depends on inter-firm rivalry
Light unless there is threat of entry
Herfindahl Index
• Rank all market shares from highest to
lowest
• Square all market shares and sum
– Produces larger “penalties” for large market
shares
Market Structures
• Handout
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Perfect Competition
Monopolistic Competition
Oligopoly
Monopoly
Market Structure and Dynamic
Competitive Forces
• A monopoly market may produce the same
outcomes as a competitive market (due to the
threat of entry)
• A market with as few as two firms can exhibit
fierce competition
• Competition as Process
– Schumpeter “the gale of creative destruction”
– Von Hayek “How easy it is for the inattentive manager
to allow profits to slip away”
– Innovation and progress
Perfect Competition
• Assumptions
– Many sellers who sell a homogenous product
– Buyers and sellers are well-informed buyers (“perfect
knowledge”)
– Sellers can enter and exit freely
– Often “large numbers of buyers and sellers” – but not
always
• Produces PRICE TAKERS where each firm faces
a perfectly elastic demand
Dynamic Condition - Zero Profits
over the Long Run
• Economic profits are driven towards zero due to
entry and exit
• Percentage contribution margin or per unit profits
• PCM = (P - MC)/P
– where P is price and MC is marginal
• When profits are maximized PCM = 1/
– where  is the elasticity of demand
• Since  is infinity, PCM approaches 0 in the limit
Conditions for Fierce Price
Competition
• Even if these ideal conditions are not
present, price competition can be fierce
when
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There are many sellers
The product is perceived to be homogenous
Excess capacity exists
Contestable Markets exist
Many Sellers
• With many sellers, collusive agreements become
difficult to create and maintain
• Cartels fail eventually because some players will
be tempted to cheat because
– Effective cartels raise prices and profits
– Small cheaters may go undetected
Price
• Even if the industry PCM is high, a low-cost
producer may prefer to set a low price
• “Remember the Demand Curve”
Davey Elasticity Crockett
• Raises prices against anything but a perfectly
inelastic demand curve means losing quantities
Homogenous Products
• Make for better substitutes!
– Customers are more likely to price shop when
the product is perceived to be homogenous
– Hence, customer switching may be the largest
source of revenue gain
• this will create great interdependence in pricing and
high levels of competition among firms in the
industry
Excess Capacity
• When a firm is operating below full capacity it can
price below average cost and operate with
economic losses for some time period so long as
the price covers variable costs
• If industry has excess capacity, prices may fall
below average cost and some firms may choose to
exit
• If exit is not an option (capacity is industry
specific) excess capacity and losses can persist
Contestable Markets
• the viable threat of competition from interloper
firms is enough to keep firms acting as if it had
actual competitors.
• Critical role of entry to dissipate profits
• Low barriers to entry required
• “Hit-and-Run” entry results
Monopoly
• The sole producer of a product for which there are
no good substitutes
• A monopolist faces little or no competition in its
product market
• A monopolist can set price – but is still subject to
the demand curve
• A monopolist profit maximizes
– equilibrate marginal revenue and marginal costs
– price on the demand curve
• PRICE SEARCHERS
Monopoly and Output
• A monopolist perpetually under stocks the market
and charges too high a price - Adam Smith
• Price exceeds the competitive price
• Price exceeds the marginal costs of production
• Output is below the competitive level
Monopoly and Innovation
• A monopolist often succeeds in becoming one by
either producing more efficiently than others in the
industry or meeting the consumers’ needs better
than others
• Hence, consumers may be net beneficiaries in
situations where a firm succeeds in becoming a
monopolist
Monopoly and Innovation,
continued…
• Monopolists are more likely to be innovative
(relative to firms facing perfect competition)
because they can capture some of the benefits of
successful innovation
• Since consumers also benefit from these
innovations, they can actually be hurt in the long
run if the monopolist’s profits are restricted
Monopolistic Competition
• There are many sellers and they believe that their
actions will not materially affect their competitors
• Each seller sells a differentiated product
• Under monopolistic competition each firm’s
demand curve is downward sloping rather than
horizontal but it is very elastic for the firm – due
to the availability of many close substitutes
Vertical and Horizontal
Differentiation
• Vertically differentiated products unambiguously
differ in quality
• Horizontally differentiated products vary in certain
product characteristics to appeal to distinct
consumer groups
– An important source of horizontal differentiation is
geographical location
Spatial Differentiation
• Video rental outlets (or grocery stores) attract
clientele based on their location
• Consumers choose the store based on their
“transportation costs”
• Transportation or transactions costs prevent
switching for small differences in price
Spatial Differentiation
• The idea of spatial location and transportation
costs can be generalized for any attribute
• Consumer preferences will be analogous to the
consumers’ physical location and the product
characteristic will be analogous to store location
Spatial Differentiation
• “Transportation costs” can be viewed as the cost
of the mismatch between the consumers’ tastes
and the product’s attributes
• Products are not perfect substitutes for each other
and for consumers some products are better
substitutes than others
– i.e., they have low “transportation costs”
Monopolistic Competition
• Many firms with non-interdependent price and
quantity decisions
• Many buyers
• Low barriers to entry and exit
• Close, but differentiated, substitutes
– Burger King has a monopoly on “The Whopper” but
there are many close substitutes
Theory of Monopolistic Competition
• An important determinant of a firm’s
demand is customer switching – if products
are viewed as close substitutes switching is
more likely
• Switching is less likely when
– customer preferences are idiosyncratic
– customers are not well informed about
alternative sources of supply
– customers face high transportation costs
Theory of Monopolistic Competition
Theory of Monopolistic Competition
• The demand curve DD is for the case when all
sellers change their prices in tandem and
customers do not switch between sellers
• The demand curve dd is for the case when one
seller changes the price in isolation and customers
switch sellers
• Sellers’ pricing strategy will depend on the slope
of dd or how likely consumers are to switch
Theory of Monopolistic Competition
• If dd is relatively steep, sellers have no incentive
to undercut their competitors since customers
cannot be drawn away from them
• If dd is relatively flat (stores are close to each
other, products are not well differentiated) sellers
lower prices to attract customers and end up with
low contribution margins
Monopolistic Competition and Entry
• Since each firm’s demand curve is downward
sloping, the price will be set above marginal cost
• If price exceeds average cost, the firm will earn
short run economic profit
• But ease of entry with short run economic profits
will attract new entrants until each firm economic
profit is zero
• Long run economic profit is zero
Theory of Monopolistic Competition
• Even if entry does not lower prices (highly
differentiated products), new entrants will take
away market share from the incumbents
• The drop in revenue caused by entry will reduce
the economic profit
• If there is price competition (where products are
not well differentiated) the market mimics pure
competition and the erosion of economic profits is
rapid
Oligopoly
• Market has a small number of sellers
• Pricing and output decisions by each firm affects
the price and output in the industry
• Oligopoly models (Cournot, Bertrand) focus on
how firms react to each other’s moves
Cournot Duopoly
• In the Cournot model each of the two firms pick
the quantities Q1 and Q2 to be produced
• Each firm takes the other firm’s output as given
and chooses the output that maximizes its profits
• The price that emerges clears the market (demand
= supply)
Cournot Reaction Functions
Cournot Equilibrium
• If the two firms are identical to begin with,
their outputs will be equal
• Each firm expects its rival to choose the
Cournot equilibrium output
• If one of the firms is off the equilibrium,
both firms will have to adjust their outputs
• Equilibrium is the point where adjustments
will not be needed
Cournot Equilibrium
• The output in Cournot equilibrium will be
less than the output under perfect
competition but greater than under joint
profit-maximizing collusion
• As the number of firms increases, the output
will drift towards perfect competition and
prices and profits per firm will decline
Bertrand Duopoly
• In the Bertrand model, each firm selects its
price and stands ready to sell whatever
quantity is demanded at that price
• Each firm takes the price set by its rival as a
given and sets its own price to maximize its
profits
• In equilibrium, each firm correctly predicts
its rivals price decision
Bertrand Reaction Functions
Bertrand Equilibrium
• If the two firms are identical to begin with,
they will be setting the same price
• The price will equal marginal cost (same as
perfect competition) since otherwise each
firm will have the incentive to undercut the
other
Cournot and Bertrand Compared
• If the firms can adjust the output quickly,
Bertrand type competition will ensue
• If the output cannot be increased quickly
(capacity decision is made ahead of actual
production) Cournot competition is the
result
• In Bertrand competition two firms are
sufficient to produce the same outcome as
infinite number of firms
Bertrand Competition with
Differentiation
• When the products of the rival firms are
differentiated, the demand curves are
different for each firm and so are the
reaction functions
• The equilibrium prices are different for each
firm and they exceed the respective
marginal costs
Bertrand Competition with
Differentiation
• When products are differentiated, price
cutting is not as effective a way of stealing
business
• At some point (with prices still above
marginal costs) reduced contribution margin
from price cuts will not be offset by
increased volume by customers switching
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 need to study the
relation between concentration and pricecost margin
• Most studies focus on specific industries
and compare geographically distinct
markets
Evidence: Concentration and
Price
• For several industries, prices are found to be
higher in markets with fewer sellers
– In markets where the top three gasoline retailers
had 60% share, prices were 5 percent higher
compared to markets where the top three had a
50% share
– For service providers such as doctors and
physicians, three sellers were enough to create
intense price competition
Economies of Scale and
Concentration
• Industries with large minimum efficient
scales compared to the size of the market
tend to exhibit 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
• 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