Textbook questions: Competitors and Competition

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1 Competitors and Competition This chapter focuses on how market structure affects competition. It begins with a discussion of how to identify competitors, define markets, and describe the market structure. First, the chapter discusses a qualitative way to define a market: two products are in the same market if they are substitutes. This can be determined by looking at the cross price elasticities. This chapter also introduces two ways to measure how concentrated the market is: the N-firm concentration ratio and the Herfindal index. The chapter then considers competition and financial performance within four broad classes of market structure: perfectly competitive markets; monopolistically competitive markets; oligopolistic markets; and monopoly markets. A perfectly competitive market has many sellers. The product is homogeneous and excess capacity exists. As a result, any one firm is discouraged from raising its prices and industry profits are driven to zero. Monopolistically competitive markets have many sellers, but each seller produces a product that is slightly differentiated from other products in the market. An oligopoly is a market in which the actions of individual firms have an impact on the industry price level and the profits of other firms in the market. There are two theories of how firms may behave in these markets: Cournot quantity competition and Bertrand price competition. Finally, this chapter discusses recent research on the impact of market structure on the price level, profitability of firms and industries. Textbook questions: 1. How would you characterize the nature of competition in the restaurant industry? Are there submarkets with distinct competitive pressures? Are there important substitutes that constrain pricing? Given these competitive issues, how can a restaurant be profitable? 2. In a recent antitrust case, it was necessary to determine whether certain elite schools (mainly Ivy League schools and MIT) constituted a separate market. How would you go about identifying the market served by these schools? 3. Numerous studies have shown that there is usually a systematic relationship between concentration and price. What is this relationship? Offer two brief explanations for this relationship. 4. The relationship described in question 3 does not always appear to hold. What factors, besides the number of firms in the market, might affect margins? 5. How does industry-level price elasticity of demand shape the opportunities for making profit in an industry? How does firm-level price elasticity of demand shape the opportunities for making profit in an industry? 6. The only way to succeed in a market with homogeneous products is to produce more efficiently than most firms. Comment. Does this imply that efficiency is less important in oligopoly and monopoly markets? 7. The dancing machine industry is a duopoly. The two firms, Chuckie B Corp. and Gene Gene Dancing Machines, compete through Cournot quantity-setting competition. The demand curve for the industry is P = 100 Q, where Q is the total quantity produced by Chuckie B and Gene Gene. Currently, each firm has marginal cost of $40 and no fixed cost. Show that the equilibrium price is $60, with each firm producing 20 machines and earning profits of $400.

2 8. The following are the approximate market shares of different brands of soft drinks during the 1980s: Coke 40%; Pepsi 30%; 7-Up 10%; Dr. Pepper 10%; all other brands 10%. a. Compute the Herfindahl for the soft drink market. Suppose Pepsi acquired 7-Up. Compute the post-merger Herfindahl. What assumptions did you make? b. Federal antitrust agencies would be concerned to see a Herfindahl increase of the magnitude you computed in (a), and might challenge the merger. Pepsi could respond by offering a different market definition. What market definitions might they propose? Why would this change the Herfindahl? Review for solving problems: Based on a single demand function and the same cost functions for firms, this review will go through all the different equilibria based on different market structures. Suppose that demand is given by P = 200-Q and the firm s cost function is TC(Q) = 40Q. That means that the firm s marginal cost is 40. Cartel/Monopolist Here there could be only one firm or several firms colluding so that they can maximize their profits. If the firms didn t collude, they would each end up with lower profits, as we will see below in the oligopoly case. First, we set MC = MR and solve for Q*: Total revenue for the monopolist is TR(Q) = (200 Q)Q Marginal revenue is just the first derivative with respect to Q: MR(Q) = 200-2Q Setting marginal revenue equal to marginal cost and solving for Q*, we have: 200 2Q = = 2Q 80 = Q* To find P*, we just replace the Q* in the demand function: P* = = 120 To find total profits, we simply take the average profit per unit and multiply it by the number of units sold: Profits = (120-40)80 = 80*80 = 6400

3 If there were one firm, then its profits are If there were two firms, then each would receive 3200 (6400/2). One important point is that if there were fixed costs, then the cartel problem would be more complicated. For instance, it would make more sense for one firm to produce all the output and then divide up the profits across all the firms equally. As we will see, these firms produce less than they would if they were involved in any form of competition Cournot, Bertrand or perfect. This allows them to set a higher price and earn higher profits. This follows our standard intuition about concentration. Oligopoly Cournot Competition Suppose now that there are two firms. The total quantity produced is the sum of the firms output. So, Q=q1 + q2. Now to solve the problem, each firm must take into account what the other firm is doing. Again, we need to set marginal revenue equal to marginal cost, but the marginal revenue is that for an individual firm. Recall that the total revenue for an individual firm is the prevailing market price times the quantity that an individual firm produces: TR1 = (200 q1 q2)q1 TR2 = (200 q1 q2)q2 To find the marginal revenue, we need to take the derivative of the firm s total revenue with respect to its own output: MR1 = 200 2*q1 q2 MR2 = 200 q1 2*q2 Next, we set them equal to the individual firm s marginal cost: 200-2*q1-q2 = q1-2*q2 = q2 = 2*q1 160-q1 = 2*q2 80 ½*q2 = q1 80 ½*q1 = q2 So, these are the firms reaction functions. Note that because both firms have the same marginal costs, they have symmetric (in that you can replace q1 with q2) reaction functions. This means that all the firms will produce the same quantity. However, if they have different fixed costs, this will have no effect on the marginal costs, but it will mean that while they sell the same amount of the product, they may make different levels of profits. (The one with the higher fixed costs will make less profit.) By replacing the q2 in firm 1 s reaction function with firm 2 s reaction function, we have: 80 ½*(80 ½ *q1) = q1 Now, we need to solve for q1: ¼*q1 = q1 40 = 3/4*q = q1

4 Because the marginal costs are the same, we know that both firms will be producing the same level of output. We can verify this by replacing q1 with in firm 2 s reaction function: 80 ½ *(53.33) = q = q2 Finally, we can find the price and the firms profit: P* = 200 ( ) = Profits for firm 1 (2): ( )*53.33 = This implies that each firm is worse off because they didn t collude. (The individual profits here are lower than in the first case of cartel.) The reason that they are worse off is because they produce a higher level of output than they would if they could agree to collude. Remember, that if the fixed costs were different for the two firms, their profits would differ as well. For instance, if firm 1 had fixed costs of 10 and firm 2 didn t have fixed costs, their profits would be and , respectively. As practice, you may want to consider what happens when the marginal cost for one of the firms is higher than the other. Bertrand Suppose that the firms choose prices instead of quantities and that prices must be announced in dollars and cents. Then $15.71, $45.95, and $39.00 would be permissible, but $ and $ would not. In this case, both firms have an incentive to announce a price below their competitor, but not less than their own marginal cost. Since both firms have the same marginal cost, they will both announce $40. (If one firm announced a price above it, say $40.01 for instance, it would not sell any output and the entire quantity demanded would come from the other firm.) In this case, neither firm makes a profit and the quantity each produces is half the quantity sold: Q = = 160 and Q/2 = 80. Perfect Competition In this case, we know that marginal revenue is equal to the price. (Individual firms face perfectly elastic demand curves, so any changes in the quantity will have no effect on the price in the market.) That means that when we set marginal cost equal to marginal revenue, it s the same as setting marginal cost equal to the price: 40 = P Taking that, we can find the total quantity sold in the market: Q = = 160.

5 Since P is equal to the marginal cost, there are no profits and the total quantity is divided by the firms in the market. If there are 10 firms, each produces 16 units. As in the Bertrand case, the quantity is higher than in the Cournot or Monopoly/Cartel. Profits and price are low.