Chapter 8 Competitors and Competition

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1 Chapter 8 Competitors and Competition Prof. Jepsen ECO 610 Lecture 4 December 6, 2012 John Wiley and Sons

2 Competition If one firm s strategic choice adversely affects the performance of another, they are competitors A firm may have competitors in several input markets and output markets at the same time Competition can be either direct or indirect

3 Direct and Indirect Competitors Direct competitors: Strategic choice of one firm directly affects the performance of the other Indirect competitors: Strategic choice of one firm affects the performance of the other because of a strategic reaction by a third firm

4 Characteristics of Substitutes Two products tend to be close substitutes when They have similar performance characteristics They have similar occasion for use and They are sold in the same geographic area

5 Performance Characteristics Empirical approaches to competitor identification Cross price elasticity of demand Pattern of price changes over time Product characteristics Products that belong to the same genre or the same SIC (industry code) need not be substitutes

6 Market Structure Markets are often described by the degree of concentration Common measure is N-firm concentration ratio = combined market share of the largest N firms (such as 4 or 20) Another is Herfindahl index, the sum of squared market shares

7 Measuring Market Structure Monopoly is one extreme with the highest concentration - one seller Perfect competition is the other extreme with many, many sellers

8 Four Classes of Market Structure Nature of Competition Perfect competition Monopolistic competition Range of Herfindahls < 0.2 usually < 0.2 usually Price Competition Intensity VERY intense Depends on product differentiation Oligopoly 0.2 to 0.6 Depends on interfirm rivalry Monopoly 0.6 to 1 Usually light, except when threat of entry

9 Competition Level Varies within Market Structure A monopoly market may produce the same outcomes as a competitive market A market with as few as two firms can lead to fierce competition With monopolistic competition, level of product differentiation determines the intensity of price competition Do not rely solely on Herfindahl index!!!

10 Perfect Competition Many sellers of homogenous product Consumers can costlessly shop around and sellers can enter and exit costlessly Each firm faces infinitely elastic demand Market decides price Firm produces quantity where marginal cost = marginal benefit Economic profits approach zero

11 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

12 Many Sellers With many sellers, cartels and collusive agreements are harder to create Cartels fail since some players will be tempted to cheat since small cheaters may go undetected

13 Homogeneous Products For firms that cut prices, customers switching from a competitor are likely to be the largest source of revenue gain Other possibility is to induce customer to purchase more than originally planned Customers are more likely to price shop when the product is perceived to be homogenous and hence sellers are more likely to compete on price

14 Excess Capacity When a firm is operating below full capacity it can price below average cost as price covers the variable cost If industry has excess capacity, prices 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 for a while

15 Monopoly A monopolist faces little or no competition in the product market If some fringe firms exist, their decisions do not materially affect the monopolist s profits Monopolist s profit is maximized by setting price where, for last unit sold, marginal revenue = marginal cost

16 Monopoly Example Suppose that Baghdatis Tennis Academy is a monopoly and faces a demand curve of P = 80 Q and has a marginal cost of 20. Total revenue is P*Q = 80Q Q 2 Marginal revenue is 80 2Q Set MR = MC, 80 2Q = 20. So Q = 30 Thus, P = 50, well above marginal cost.

17 Monopolistic Competition There are many sellers and they believe that their actions will not materially affect their competitors Each seller sells a differentiated product Unlike under perfect competition, in monopolistic competition each firm s demand curve is downward sloping rather than flat

18 Vertical and Horizontal Differentiation Vertically differentiated products unambiguously differ in quality Example: Easyjet vs British Airways Horizontally differentiated products vary in certain product characteristics to appeal to different consumer groups Example: jazz clubs versus techno clubs An important source of horizontal differentiation is geographical location

19 Geography and Horizontal Differentiation Grocery stores attract clientele based on their location Some grocery stores even offer delivery Consumers choose the store based on transportation costs Transportation costs prevent switching for small differences in price

20 Differences in Preferences Horizontal differentiation possible when tastes differ markedly between people Book calls this idiosyncratic preferences Location and taste are important sources of these differences in preferences Gelato flavors, car attributes, clothes style Search costs discourage switching when prices are raised

21 Search Costs and Differentiation Search cost: Cost of finding information about alternatives Low-cost sellers try lower the search costs, often through advertising Some markets have high search costs Examples: physicians, hair stylists

22 Switching Costs and Monopolistic Competition An important determinant of a firm s demand is customer switching Switching is less likely when Customer preferences vary greatly Customers are not well informed about alternative sources of supply Customers face high transportation costs

23 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

24 Cournot Duopoly Two firms that produce identical products Firms pick the quantities Q 1 and Q 2 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)

25 Cournot Duopoly Example Suppose P = 80 Q 1 Q 2 ; MC = 20 Q 1 profit = revenue total cost = (P * Q 1 ) (20 * Q 1 ) We can simplify this equation to = 60 * Q 1 Q 1 2 Q 1 * Q 2 Profit maximizing output for firm 1 is: Q 1 * = * Q 2 *

26 Cournot Reaction Functions Q 2 Not to scale! Total oligopoly output is 40. Monopoly output is 30. Perfect competition output is Q 2* =20 Q 1* =20 30 Q 1

27 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

28 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

29 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 rival s price decision

30 Bertrand Reaction Functions Note: assumes identical products P 2 Firm 1 s reaction function P* Firm 2 s reaction function P* P 1

31 Bertrand Equilibrium If the two firms are identical to begin with, they will be setting the same price as each other The price will equal marginal cost (same as perfect competition) since otherwise each firm will have the incentive to undercut the other

32 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

33 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

34 Bertrand Competition with Differentiation (Continued) When products are differentiated, price cutting is not as effective a way to steal business At some point (prices still above marginal costs), the lost revenue from price cuts will not be offset by increased volume by customers switching