Economics of Strategy

Economics of Strategy
Market Structures
Dynamic Competition
Substitutes and Cross-Price
• “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
% 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
• 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
– 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…
CD Player
Tape Player
Eight…. No don’t go there
MP3 Files
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
• 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
Coca Cola’s Market
• Is Coca Cola’s market, the market for cola drinks
or the market for all potable liquids (including tap
• 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
• 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
• 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
• 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
• Entropy could be another measure of
– How fast do competitors disappear and appear?
Herfindahl Index
Perfect Competition
Herfindahl Index
Usually < 0.2
Usually < 0.2
0.2 to 0.6
> 0.6
Intensity of Price Competition
Depends on the degree of product
Depends on inter-firm rivalry
Light unless there is threat of entry
Herfindahl Index
• Rank all market shares from highest to
• Square all market shares and sum
– Produces larger “penalties” for large market
Market Structures
• Handout
Perfect Competition
Monopolistic Competition
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
– Sellers can enter and exit freely
– Often “large numbers of buyers and sellers” – but not
• 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
• Even if these ideal conditions are not
present, price competition can be fierce
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
• 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
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
• 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
• 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
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
Monopoly and Innovation,
• 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
• 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
• 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
• 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
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
• In Bertrand competition two firms are
sufficient to produce the same outcome as
infinite number of firms
Bertrand Competition with
• 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
• When products are differentiated, price
cutting is not as effective a way of stealing
• 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
• 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
• 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
Evidence: Concentration and
• 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
• 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