MARKET STRUCTURE

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MARKET STRUCTURE
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Lecture Contents

• Defining markets and competitors
• Review of market structures
• Perfect competition
• Monopoly
• Monopolistic competition
• Oligopoly
• Concentration and profitability

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Recognizing competitors

• Every firm selling substitutes is a competitor
• Cross price elasticity measures the extent to
  which two products substitute
• Firm has competitors both on the market for its
  product and markets for its inputs

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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

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Market Definition

• 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 others 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)

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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

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Measuring Market Structure

• A common measure of concentration is the N-firm
  concentration ratio - combined market share of
  the largest N firms
• Herfindahl-Hirschman index is another which
  measures concentration as the sum of squared
  market shares
• 1 / HH Number of firms equivalent

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Primer
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Four Classes of Market Structure
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Market Structure and Competition

• A monopoly market may produce the same outcomes
  as a competitive market (threat of entry)
• A market with as few as two firms can lead to
  fierce competition
• With monopolistic competition, how well
  differentiated the products are will determine
  the intensity of price competition

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Perfect Competition

• Many sellers who sell a homogenous product and
  many well informed buyers
• Consumers can costlessly shop around and sellers
  can enter and exit costlessly
• Each firm faces infinitely elastic demand

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Zero (longterm) Profit Condition

• Profit maximization MC MR P
• Percentage contribution margin PCM equals (P -
  MC)/P where P and MC are price and marginal cost
  respectively
• When profits are maximized PCM 1/? where ? is
  the elasticity of demand
• Since ? is infinity for each firm, PCM 0
• In case of perfect competition longterm profits
  tend to go to 0.

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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

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Many Sellers

• With many sellers, cartels and collusive
  agreements harder to create
• Cartels fail since some players will be tempted
  to cheat since small cheaters may go undetected
• Even if the industry PCM is high, a low cost
  producer may prefer to set a low price

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Homogenous Products

• For firms that cut prices, customers switching
  from a competitor are likely to be the largest
  source of revenue gain
• 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

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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 will persist
  for a while

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Monopoly

• A monopolist faces little or no competition in
  the product market
• Monopolist can act in an unconstrained way in
  setting prices
• If some fringe firms exist, their decisions do
  not materially affect the monopolists profits

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Monopoly and Output

• A monopolist sets the price so that marginal
  revenue equals marginal cost
• Thus the monopolists price is above the marginal
  cost and its output below the competitive level
• The traditional anti-trust view is that limited
  output and higher prices hurt the consumer

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Monopoly and Output
PC
QC
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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

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Monopoly and Innovation

• Monopolists are more likely to be innovative
  (than firms facing perfect competition) since
  they can capture some of the benefits of
  successful innovation
• Since consumers also benefit from these
  innovations, they are hurt in the long run if the
  monopolists profits are restricted

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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 firms demand curve is downward
  sloping rather than flat

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Vertical and Horizontal Differentiation

• Vertically differentiated products unambiguously
  differ in quality
• Horizontally differentiated products vary in
  certain product characteristics to appeal to
  different consumer groups
• An important source of horizontal differentiation
  is geographical location

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Spatial Differentiation

• Video rental outlets (or grocery stores) attract
  clientele based on their location
• Consumers choose the store based on
  transportation costs
• Transportation costs prevent switching for small
  differences in price

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Spatial Differentiation

• The idea of spatial location and transportation
  costs can be generalized for any attribute
• Consumer preferences will be analogous to
  consumers physical location and the product
  characteristic will be analogous to store
  location
• Transportation costs will be the cost of the
  mismatch between the consumers tastes and the
  products attributes
• Products are not perfect substitutes for each
  other
• Some products are better substitutes (low
  transportation costs) than others

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Theory of Monopolistic Competition

• An important determinant of a firms demand is
  customer switching
• Switching is less likely when
• customer preferences are idiosyncratic
• customers are not well informed about alternative
  sources of supply
• customers face high transportation costs

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Theory of Monopolistic Competition
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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

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Theory of MonopolisticCompetition

• 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

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Monopolistic Competition and Entry

• Since each firms demand curve is downward
  sloping, the price will be set above marginal
  cost
• If price exceeds average cost, the firm will earn
  economic profit
• Existence of economic profits will attract new
  entrants until each firm economic profit is zero

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Monopolistic Competition and Entry

• 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 (products that are
  not well differentiated) the erosion of economic
  profit will be quicker

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Short-term and long-term equilibrium in
monopolistic competition
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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 others moves

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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 firms output as given
  and chooses the output that maximizes its profits
• The price that emerges clears the market (demand
  supply)
• Every competitor maximizes profits by setting MR
  MC

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Cournot Duopoly

• Example
• Market demand P 30 Q,
• where Q Q1 Q2
• MC1 MC2 0

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Cournot Reaction Functions
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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

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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

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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

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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

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Bertrand Reaction Functions (differentiation)
Demand functions of the two firms Q112-2P1P2 Q2
12-2P2P1
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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

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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 inter-industry
  variation in price-cost margins (regulation,
  accounting practices, concentration of buyers and
  so on)

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Price-Cost Margins and Concentration

• For several industries, prices are found to be
  higher in markets with fewer sellers
• In markets where the top three gasoline retailers
  had sixty percent share prices were 5 percent
  higher compared to markets where the top three
  had a fifty percent share
• For service providers such as doctors and
  physicians, three sellers were enough to create
  intense price competition

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Economies of Scale and Concentration

• Industries with large minimum efficient scales
  compared to the size of the market tend to have
  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

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Entry and Exit
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Lecture Contents

• Forms of entry and exit
• Entry barriers
• Exit barriers
• Entry deterring strategies

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Forms of Entry

• Entry could take place in different forms
• An entrant may be a brand new firm (Example
  Dreamworks SKG)
• An entrant may also be an established firm that
  is diversifying into a new product/market
  (Example Amazon.com selling CDs)
• The form of entry is important when we analyze
  entry costs and strategic response to entry by
  the incumbents

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Forms of Exit

• Exit could also take different forms
• A firm may simply fold up (Example PanAm)
• A firm may discontinue a particular product or
  product group or leave a particular market (Fiat
  leaves the U.S. market)

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Cost Benefit Analysis for Entry

• A potential entrant compares the sunk cost of
  entry with the present value of the post-entry
  profit stream
• Sunk costs of entry range from investment in
  specialized assets to government licenses
• Post-entry profits will depend on demand and cost
  conditions as well as the nature of post-entry
  competition

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Barriers to Entry

• Barriers to entry are factors that allow the
  incumbents to earn economic profit while it is
  unprofitable for the new firms to enter the
  industry
• Barriers to entry can be classified into
• structural barriers to entry and
• strategic barriers to entry

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Barriers to Exit

• Barriers to exit are factors that make the firm
  continue producing under such conditions which
  would not have encouraged the firm to enter
• Examples of such barriers are specialized assets
  labor agreements, commitment to suppliers and
  governmental regulations

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Structural Barriers to Entry

• Structural barriers to entry exist when
• the incumbent has cost advantages or marketing
  advantages over the entrants
• incumbents are protected by favorable government
  policy and regulations

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Strategic Barriers to Entry

• Strategic entry barriers are barriers created and
  maintained by the incumbents
• Incumbents can erect strategic barriers by
  expanding capacity and/or resorting to limit
  pricing and predatory pricing

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Typology of Entry Conditions

• Markets can be characterized by whether the
  existing barriers to entry are structural or
  strategic
• Three entry conditions according to Joe Bain are
• blockaded entry
• accommodated entry
• deterred entry

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Blockaded Entry

• Entry is considered to be blockaded when the
  incumbent does not need to take any action to
  deter entry
• Existing structural barriers are effective in
  deterring entry

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Accommodated Entry

• When the conditions call for accommodated entry,
  the incumbents should not bother to deter entry
• This condition is typical of markets with growing
  demand or rapid technological change
• Structural barriers may be low and strategic
  barriers may be ineffective in deterring entry or
  simply not cost effective

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Deterred Entry

• Entry is not blockaded
• Entry deterring strategies are effective in
  discouraging potential rivals and are cost
  effective
• Deterred entry is the only condition under which
  the incumbents should engage in predatory acts.

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Types of Structural Barriers

• The three main types of structural barriers to
  entry are
• Control of essential resources by the incumbent
• Economies of scale and scope
• Marketing advantage of incumbency

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Control of Essential Resources

• Nature may limit the sources of certain inputs
  and the incumbents may be in control of these
  limited sources
• Patents can prevent rivals from imitating a firms
  products
• Special know how that is hard for the rivals to
  replicate may be zealously guarded by the
  incumbents

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Economies of Scale and Scope

• If economies of scale are significant, incumbent
  may face a high threshold of market share to be
  profitable
• Incumbents strategic reaction to entry may
  further lower price and cut into entrants
  profits
• If entrant succeeds, intense price competition
  may ensue

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Economies of Scale and Scope

• Economies of scope in production may exists when
  multiple products that share inputs and
  production technology are produced in the same
  plant
• Economies of scope in marketing are due to the
  bulky up front expenditure an entrant has to
  incur to achieve comparable brand awareness as
  the incumbents brand

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Marketing Advantage of Incumbency

• Incumbent can exploit the brand umbrella
  (different products sold under the same brand
  name) to introduce new products more easily than
  new entrants can
• The brand umbrella can make it easy for the
  incumbent to negotiate the vertical channel
  (Example It is easier to get shelf space with an
  established brand)

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Marketing Advantage of Incumbency

• Exploitation of the brand name and reputation is
  not risk-free
• If the new product is unsatisfactory, customer
  dissatisfaction may harm the image of the rest of
  the brands

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Entry Deterring Strategies

• Some examples of entry deterring strategies are
  limit pricing, predatory pricing and capacity
  expansion
• For these strategies to work
• incumbent must earn higher profits as a
  monopolist than as a duopolist and
• the strategy should change the entrants
  expectations regarding post-entry competition

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Limit Pricing

• An incumbent using the limit pricing strategy
  will set the price sufficiently low to discourage
  entrants
• The entrant observes the low price and concludes
  that the post entry price will be low as well and
  decides not to enter

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Flaws in the Limit Pricing Model

• When multiple periods are considered, the
  incumbent has to set the price low in each period
  to deter entry in the next period
• Thus, the incumbent never gets to raise the price
  and does not reap the benefits of entry deterrence

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Situations When Limit Pricing Works

• Limit pricing will work if the incumbent has a
  cost advantage over the entrant
• With a cost advantage, the incumbent can set the
  price slightly below entrants minimum average
  cost, ensuring that entrant can not make profits

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Situations When Limit Pricing Works

• Limit pricing will work if the entering firm in
  uncertain regarding the market demand or some
  determinant of post-entry pricing such as
  incumbents marginal cost
• If entrant can predict post-entry price, its
  decision to enter or not will be independent of
  the incumbents strategy

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Predatory Pricing

• A firm using the predatory pricing strategy sets
  the price below short run marginal cost with the
  expectation of recouping the losses when the
  rival exits
• Limit pricing is directed at potential entrants
  while predatory pricing is directed at entrants
  who have already entered

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Is Predatory Pricing Rational?

• If all the entrants can perfectly foresee the
  future course of incumbents pricing, predatory
  pricing will not deter entry
• Predatory pricing will work only if the low price
  by the incumbent signals low marginal cost or
  indicate that the incumbent is more concerned
  about market share than about profits

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War of Attrition

• In a price war, larger players may have better
  staying power (larger cash reserves, better
  access to credit)
• Larger players also incur a greater cost
  (especially if they do not have a cost advantage)

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Winning the War of Attrition

• The more a firm believes it can outlast its
  rivals, the more willing it will be to begin and
  continue with a price war
• A firm that faces exit barriers is well
  positioned to engage in a price war
• A firm can also try to convince its rivals that
  it can outlast them (For example, by claiming
  that they are making money even during the price
  war

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Excess Capacity and Entry Deterrence

• By holding excess capacity, the incumbent can
  credibly threaten to lower the price if entry
  occurs
• Since an incumbent with excess capacity can
  expand output at a low cost, entry deterrence
  will occur even when the entrant is completely
  informed about the incumbents intentions

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Excess Capacity is Not Always Strategic

• When capacity addition has to be lumpy, firms may
  often have excess capacity in anticipation of
  future growth
• A temporary down turn in demand may leave the
  firms in an industry with excess capacity with no
  strategic overtones

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Evidence on the Use of Entry Deterring Strategies

• Reported Use of Entry Deterring Strategies
• Aggressive price reductions to move down the
  learning curve
• Intensive advertising to create brand loyalty
• Acquiring patents
• Enhancing reputation for predation using
  announcements and other means
• Limit pricing
• Holding excess capacity