1 Case Study: Airbus Versus Boeing
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1 MAE 214: ECONOMIC STRATEGY FOR BUSINESS LECTURE 6 Market Structure and Competition; Entry and Exit 1 Case Study: Airbus Versus Boeing Since the end of 1990s, Airbus and Boeing possess a duopoly in the large commercial jet market. Comparisons on Main Models The Airbus A380 is substantially larger than the Boeing 747 The Airbus A350 competes with the high end of the Boeing 787 Dreamliner and the Boeing 777 The Airbus A320 is larger than the Boeing but smaller than the The Airbus A321 is larger than the Boeing but smaller than the previous Boeing
2 The Airbus A competes with the similar Boeing ER and the Boeing ER. Market Share Trend since 1995 (in net order) 2016 Net Market Share 2016 Market Shares by Category 2011JET ORDERS The 2011 sales success of the new A320neo gave Airbus a huge win. 2
3 Airbus signed up in excess of 600 jet orders more than Boeing. Boeing delivered 82 of large jets, compared with 26 superjumbo jets for Airbus. So in the dollar value, Boeing scraped just ahead of Airbus: $33 billion in revenue to Airbus s $32 billion. 3
4 Gross Orders in the last 10 years Deliveries over the last 10 years 4
5 Air Travel Trend Since 1970 Air Travel Trend Predicted by Airbus 5
6 Order Backlogs: With the high volume of backlog, Airbus and Boeing look forward to years of guaranteed business? On the other hand, the high volume of backlog indicates that market demand cannot be satisfied attracts new entrants. The Boeing-Airbus duopoly could be challenged: Two s company, five s a crowd? Economist, Nov 21st, 2012) (The Bombardier of Canada will launch its CSeries, competing in the seater narrowbody market now split between Boeing s 737 jets and Airbus s equally successful A320 family. Russia s United Aircraft Corporation is also working on a larger plane, the Irkut MC-21, to rival the 737 and A320. The Russian government said it would pump almost $40 billion into the industry by China is at least as determined as Russia to build a globally competitive aircraft industry. Its state planemaker, Comac, has less expertise in design than its Russian counterpart, but can count on a government with much deeper pockets. Brazil s Embraer, already a successful maker of regional and business aircraft, will decide whether to follow the Canadians, Russians and Chinese into the market for full-sized airliners The long-term boom in aviation must surely provide space for more than just two makers of full-sized airliners. 6
7 Airbus and Boeing have 7 new challengers (Business Insider, May 24, 2017) 2 Cournot Quantity Competition 2.1 A Simple Duopoly In a market with only a few sellers, it is reasonable to expect that the pricing and output choices of any one firm will affect rivals pricing and output and, as a result, will have a tangible impact on the overall market price and output. Economists have produced many models of oligopolistic markets. A central element of these models is the careful consideration of how firms respond to each other s choices. Two important oligopoly models: Cournot quantity competition and Bertrand price competition. Let us first consider a Cournot quantity competition model. Consider a market with only two firms: Airbus and Boeing (Duopoly) Each firm s strategy is the amount they choose to produce, q 1 for Airbus and q 2 for Boeing. Once they are committed to production, the market price is determined by the following market demand function: p = 100 q 1 q 2 Suppose that both firms have the following total costs of production: T C 1 (q 1 ) = 10q 1 T C 2 (q 2 ) = 10q 2 Therefore both firms have constant marginal costs of $10. How much will each firm produce? Because both Airbus and Boeing are aware that the market price depends on the total production they produce, the amount that Airbus desires to produce depends on how much it expects Boeing to produce, and vice versa. A Cournot equilibrium, which is a special case of Nash equilibrium, requires that 1. Airbus s optimal level of production is the best response (i.e., maximizes its profits) to the level it expects Boeing to choose 2. Boeing s optimal level of production is the best response (i.e., maximizes its profits) to the level it expects Airbus to choose 7
8 Specifically speaking, a Cournot equilibrium is a pair of outputs (q 1, q 2) that satisfies the following conditions: q 1 maximizes Airbus s profits given Boeing s choice is q 2 q 2 maximizes Boeing s profits given Airbus s choice is q 1 The profit-maximizing outputs q 1 and q 2 are determined by the standard marginal revenue equals marginal cost condition. The marginal revenue for Airbus is and the marginal revenue for Boeing is MR 1 = 100 2q 1 q 2, MR 2 = 100 2q 2 q 1. Hence q 1 and q 2 are determined by the following two conditions: Solving these two equations gives us MR 1 = 100 2q 1 q 2 = MC 1 = 10 MR 2 = 100 2q 2 q 1 = MC 2 = 10. q 1 = 30 q 2 = 30 The market price is p = 100 q 1 q 2 = = 40. What happens when the cost structures are asymmetric? Consider the following situation: T C 1 (q 1 ) = 10q 1 T C 2 (q 2 ) = 20q 2 Go over Figure 5.2 and Table 5.5 to understand the Cournot adjustment process in reaching this equilibrium. What if there are more than two firms in the market? We should expect the following results when more sellers in the market: Lower market price Higher market quantity Lower individual firm quantity Lower profits 8
9 2.2 Example 5.5 Application of Cournot Eq to Corn Wet Milling Industry in 1970s Porter and Spence s case study of the corn wet milling industry in 1970s. Firms convert corn into cornstarch and corn syrup. Corn syrup was a stable oligopoly with 11 major sellers in the 1970s. In 1972, the production of high-fructose corn syrup (HFCS) became commercially viable Firms had to decide how to add capacity to accommodate the expected demand The Cournot Eq can be used to predict the capacity expansion process Each firm s expansion decision was based on: A conjecture about the overall expansion of industry capacity, Market Demand, and Sugar Prices The predicted and actual capacity expansions are shown below: After 1976 Total (Pounds) Actual Capacity billion Predicted Capacity billion The predictions came remarkably close to the actual pattern of industry capacity expansion. 3 Bertrand Price Competition In Cournot s model, each firm selects a quantity to produce, and the resulting total output determines the market price. Alternatively, one might imagine a market in which each firm selects a price and stands ready to meet all the demand for its product at that price. In a model of Bertrand price competition, each firm selects a price to maximize its own profits, given the price that it believes the other firm will select. In Bertrand s model with firms producing idential products, rivalry between two firms result in the perfectly competitive outcome. When firms products are differentiated, as in monopolistic competition, price competition is less intense. The Cournot and Bertrand models make dramatically different predictions about the quantities, prices, and profits that will arise under oligopolistic competition. One way to reconcile the two models is to recognize that Cournot and Bertrand competition may take place over different time frames. Cournot competitors can be thought of as choosing capacities and then competing as capacity-constrained price setters. The result of this two-stage competition (first choose capacities and then choose prices) is idential to the Cournot equilibrium 9
10 in quantities. More cutthroat Bertrand competition results if the competitors are no longer constrained by their capacity choices, either because demand declines or a competitor miscalculates and adds too much capacity. The Cournot model applies most naturally to markets in which firms must make production decisions in advance, are committed to selling all of their output, and are therefore unlikely to react to fluctuations in the rivals output. This might occur if the majority of production costs are sunk, or because it is costly to hold inventories commodities such as natural gas and copper. Go over Example 5.6 on p.178 to understand what caused an electricity price spike in January 2014 in Mid-Atlantic and Midwest. 4 Strategic Commitment Strategic commitments are decisions that have long-term impacts and are diffi cult to reverse. Investing in a new production facility is a strategic commitment. Strategic commitments influence the choices made by rival firms A decision to expand capacity might deter new firms from entering the market Making strategic commitments could make a firm better off. Consider the following capacity expansion game: Firm 2 Expand Not Firm 1 Expand 12.5, , 5 Not 15, , 6 If they move simultaneously, there is a unique Nash eq: Firm 1 chooses "Not" and Firm 2 chooses "Expand" The payoff is 15 for Firm 1 in the unique Nash eq However, Firm 1 can improve his payoff by committing to choose "Expand" This strategic commitment transforms the simultaneous-move game into a sequentialmove game Firm 2 chooses its strategy after observing Firm 1 s choice. The unique Subgame Perfect Nash equilibrium (SPNE) is the following: Firm 1 chooses "Expand", and Firm 2 chooses "Not" when Firm 1 s choice is "Expand" and chooses "Expand" when Firm 1 s choice is "Not". Firm 1 s payoff now is 16.5 A strategic commitment makes Firm 1 better off. Strategic Commitment Example: Airbus versus Boeing 10
11 In December 2000, Airbus formally committed to spend about $12 billion to develop and launch the A380 super-jumbo jet with capacity of around 550. Boeing also announced to launch 747X, a higher-capacity version of the 747, to compete with Airbus. The high-capacity aircraft market is estimated to have only 400 units in demand could allow only one firm to make a profit Airbus made a credible commitment by securing over 60 early orders from Singapore Airlines, Qantas, Virgin Atlantic, UPS, and Fedex Boeing failed to secure any orders. A few months later, Boeing announced to abandon its plans to build 747X. Airbus strategic commitment successfully deterred Boeing from entering the superjumbo market. However, as strategic commitments are hard to reverse, they are inherently risky It is not clear yet whether Airbus could make a profit from this investment: The super-jumbo of all gambles, The Economist, Jan 20, Oversize Expectations for the Airbus A380, New York Times, Aug 9, oversize-expectations-for-the-airbus-a380.html?_r=0 Airbus isn t giving up on its A380 superjumbo, CNN Money, Jan 11, airbus-aircraft-orders-a380-boeing/index.html 5 Entry and Exit MySpace and Facebook. Long before the film The Social Network made Facebook founder Mark Zuckerberg a household name, another social networking web site was taking the Internet by storm. Founded in 2003 by ex-employees of Friendster (a very early social networking site), MySpace allowed members to create user communities, post content to community boards, publicize parties, and send instant messages to fellow community members. Perhaps the most exciting feature in the early days was the ability of MySpace members to create their own web pages. MySpace and its parent company were purchased in 2005 by Rupert Murdoch for $580 million, and by 2008, MySpace had over 100 million unique visitors each month, making it the most popular social networking Internet site. Few people realized it at the time, but the decline of MySpace began in 2004, when Zuckerberg launched Facebook. Facebook differed from MySpace in several critical ways. Facebook required that members use their actual names and that their web pages conform to a standard format. In contrast, MySpace members routinely used online pseudonyms, and their web pages were bastions of creative design. Facebook developed an iphone app in 2007; 11
12 MySpace did not respond until a year and 12 million iphones later. Facebook made an explicit effort to be business friendly, for example, by restricting search results. MySpace, with its roots in the Southern California music scene, was much slower to reach out to business. The rest, as they say, is history. By 2009, Facebook had over 250 million unique visitors monthly, while MySpace was on the decline. Today, MySpace hangs on by a thread, largely because there are few ongoing costs associated with maintaining the site. Entry is the beginning of production and sales by a new firm in a market. Exit is the reverse of entry the withdrawal of a product from a market, either by a firm that shuts down completely or by a firm that continues to operate in other markets. A recent study of manufacturing firms shows that entry and exit are pervasive: two-year entry and exit rates are 16 percent after five years, 65 percent of firms have exited entry and exit is more common in leather goods, footwear, and offi ce machinery, but uncommon in metal manufacturing, synthetic fibers, and plastics processing What structural factors affect entry and exit decisions? Incumbent firms should take entry into account when making their strategic decisions Entrants threaten incumbents in two ways: they take market share away from incumbent firms - share the profit pie entry often intensifies competition - reduce the size of the profit pie Barriers to Entry allow incumbent firms to earn positive economic profits while making it unprofitable for newcomers to enter the industry Barriers to entry could be structural or strategic Structural Entry Barriers Structural entry barriers exist when the incumbent has natural cost or marketing advantages, or when the incumbent benefits from favorable regulations. Strategic Entry Barriers Strategic entry barriers result when the incumbent takes aggressive actions to deter entry. Structural Entry Barriers: Control of Essential Resources: an incumbent is protected from entry if it controls a resource or channel in the vertical chain and can use that resource more effectively than newcomers. Economies of Scale and Scope Marketing Advantages of Incumbency 12
13 Scale Economies in Advertising: US Soft Drinks Control of Essential Resources DeBeers in diamonds Alcoa in aluminum Ocean Spray in cranberries: in 2002 Northland Cranberries flied an antitrust lawsuit against Ocean Spray, alleging that Ocean Spray had used its dominant position to prevent rivals from having access to retailers. The private litigation ended in 2004, when Ocean Spray acquired Northland Cranberries production facilities. Patent wars in the smartphone market Economies of Scale and Scope. The breakfast cereal industry enjoys a cost advantage from economies of scope: For several decades, the industry has virtually no new entry Kellogg, General Mills, General Foods, and Quaker Oats dominates the market Significant economies of scope in producing cereal flexibility in materials handling and scheduling from having multiple production lines within the same plant For entry to be worthwhile, a newcomer would need to introduce 6 to 12 successful brands substantial capital requirements Entry-Deterring Strategies Limit Pricing Predatory Pricing 13
14 Capacity Expansion Strategic Bundling Limit pricing refers to the practice whereby an incumbent firm discourages entry by charging a low price before entry occurs Limit pricing may not be credible (it is not a SPNE) (go over p.196-p.200 for the following example) Predatory pricing: a large incumbent sets a low price to drive smaller rivals from the market Wal-Mart and American Airlines enjoy a reputation for toughness earned after fierce price competition led to the demise of rivals However, Wal-Mart lost its battle in Germany. Go over Example 6.6 on page 204. Capacity Expansion. By holding excess capacity, an incumbent may affect how potential entrants view postentry competition and thereby blockade entry Strategic bundling 14
15 An incumbent firm that dominates one market can use its power to block entry into related markets through a practice known as strategic bundling. Bundling occurs when a combination of goods or services are sold at a price that is less than what it would cost to buy the same item separately. Some examples: McDonald s Happy Meals bundle sandwiches, French fries, and soft drinks. Vacation packages bundle transportation and lodging. Netflix bundles DVD rentals with internet streaming. 6 Industry Analysis How to access industry and firm performance? How changes in the business environment affect performance? Profitability of US Industries Michael Porter s Five Forces Analysis 15
16 Internal rivalry refers to the jockeying for share by firms within a market. Firms may involve in price competition in order to gain market share. The following factors intensify price competition: (i) Many sellers in the market, (ii) The industry is declining, (iii) Firms are asymmetric, (iv) Some firms have excess capacity, (v) Products are homegeneous/buyers have low switch costs, (vi) There are large/infrequent sales orders, (vii) There is high industry price elasticity of demand Entry. Entry heats up internal rivalry. Some factors that affect entry: (i) Economies of scale/scope, (ii) Government protection, (iii) Consumers brand loyality, (iv) Essential Resources/know-how Substitutes and Complements. Substitutes erode profits while complements boost the demand for the product. Supplier Power and Buyer Power. The following factors affect supplier power and buyer power: (i) Competitiveness of the input market, (ii) The relative concentration of the industry in question/its upstream and its downstream industries, (iii) Availability of substitute inputs, (iv) Relationship-specific investments by the industry and its suppliers. Go over the textbook for detailed discussions of each force and understand how the fiveforces analysis can be applied to evaluate the profitabilities of Airbus and Boeing in the near future. Reading List: Ch 5 and Ch 6 16
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