ECON 696: Managerial Economics and Strategy

Lecture Notes 6: Competitors and Competition

Behaving strategically means knowing who your competitors are and how they will respond to changes in your behavior. This chapter discusses different types of markets, how firms in them behave and the effects of this behavior on profitability.

The chapter starts with a discussion about the tricky processes of defining a market and identifying competitors. It also introduces the concept of market concentration.

The chapter then discusses the four standard market structures: perfect competition, monopoly, monopolistic competition and oligopoly. Oligopoly includes two types of competition: Cournot or quantity competition and Bertrand or price competition.

Finally, the relationship between market structure and profitability is examined.

Identifying Competitors and Defining Markets

1. Identifying competitors

The text describes pretty clearly what a competitor is, or how you determine whether a particular firm is a competitor. There are two important definitions.

The first definition is mathematical and is derived from the formula for elasticity. The usual form for an elasticity calculation is the percentage change in quantity divided by the percentage change in price, which may be written in a variety of ways:

In determining whether or not goods are substitutes for each other, you might calculate the percentage change in the quantity of one is divided by the percentage change in the price of the other. This version of elasticity is called the cross price elasticity.

If two goods, x and y, are being considered, the cross price elasticity of these may be described either as

or as

If two goods are substitutes, an increase in the price of one should be accompanied by an increase in the quantity of the other, holding other things constant. As a result, if two goods are substitutes, their cross price elasticity will be positive.

The second definition is descriptive and focuses on the characteristics of the product being sold. The book discusses some specifics, but in practical terms, any option that a reasonable consumer is likely to consider when making a purchase is a substitute. This will typically include goods which:

·  serve the same function

·  have similar characteristics (including price)

·  are available in the same general location.

The second definition of substitutes is more intuitive and perhaps more useful, but the first is more precise. You might agree that margarine and butter are substitutes, but what about margarine and cooking oil or vegetable shortening? Both may be used for frying, but vegetable shortening is generally not used on toast. If data could be obtained on the prices and quantities sold of margarine and vegetable shortening, a definite answer could be offered as to whether or not they are substitutes by calculating the cross price elasticity. If they are substitutes, the larger the calculated elasticity, the more likely consumers are to substitute between the two goods.

This is important because substitutes compete with each other for customers. If you can identify which goods your consumers are likely to substitute for yours, you will know which products' prices and marketing programs you need to monitor.

2. Defining markets

A market is defined by the consumers and suppliers who buy and sell goods which are close substitutes for each other.

As it is with substitutes, markets include goods which serve as practical substitutes for each other.

Market structure is described by the number of consumers and suppliers, their relative sizes and the degree to which the products sold are substitutes. In this chapter, we will focus on suppliers, although there can be important issues relating to markets with small numbers of very large consumers.

Two important aspects of market structure are concentration and product differentiation.

The degree to which a small number of firms controls a market is the level of concentration in that market. In a concentrated market, there are either a small number of firms or a small number of very large firms and, perhaps, many small ones. The automobile market in the U.S. is very concentrated because there are a small number of very large firms manufacturing and selling cars. The beer market in the U.S. is very concentrated despite the existence of many small breweries because it is dominated by a small number of extremely large companies.

The degree to which consumers are willing to substitute between products in a market is the level of differentiation in the market. If every seller is offering the same exact product at the same location and time, there is no product differentiation. If products differ in their characteristics, location or the time at which they are offered, this may increase the level of product differentiation.

Market structure is important not only because of its effects on how firms act in response to each other, but also because of its effects on an individual firm's behavior. If there are many firms in a market selling very similar products, any one firm will be unable to raise its prices very much because its customers will simply seek out another seller.

Put another way, when there are many other sellers in a market, demand for any one seller's product will be very elastic. If price increases, even by a small percentage, the resulting decrease in the quantity sold can be huge. Similarly, if a seller lowers prices, the resulting increase in quantity sold can be huge.

As an example, consider the market for gasoline. While there are no good substitutes for gasoline, the manager of any one gas station knows that the gas sold at nearby stations is a very good substitutes for the gasoline she is selling and she can lose most of her business by raising the price slightly or can have lines at the pumps by lowering it slightly.

If a market has very few sellers, or if the products are very distinct, one firm may be able to raise its prices quite a bit without losing too many customers. At some point, customers may seek out poor substitutes or simply stop buying the good, but they will tolerate some level of price increases.

3. Measures of market concentration

The most quantifiable aspect of market structure is the level of concentration of a market. There are two commonly used measures of this.

The first is a concentration ratio, a measure based on the percentage of sales made by the largest firms in the industry. A four firm concentration ratio is the percentage of the market's sales made by the four largest firms, an eight firm concentration ratio is the percentage of the market's sales made by the eight largest firms. These are useful because they are relatively easy to calculate and understand and the largest firms in a market probably have the greatest impact on how the market performs, but they are somewhat lacking both because they ignore the smaller firms in the market and they fail to recognize the importance of changes in market share between the largest firms.

For example, if the four largest firms in a market have market shares of 15%, 10%, 8% and 7%, the four firm concentration ratio would be 0.40. If the largest firm attracted customers away from the other large firms so that the market shares changed to 20%, 7%, 7% and 6%, the four firm concentration ratio would still be 0.40. This is in spite of the fact that the largest firm has gone from being 50% larger than its nearest competitor to being nearly three times its size.

A more precise measure of market concentration is given by the Herfindahl index (HI), also known as the Hirshman-Herfindahl index (HHI). This is equal to the sum of the squared market shares of each firm in the market.

For example, imagine a market with five firms which control 35%, 30%, 20%, 10% and 5% of sales. The calculated HI for this market would be

For reasons too complicated to explain here, this is sometimes multiplied by 10,000, so some people would say that the HI in this market is 2650.

The HI is a better indication of concentration because it considers the structure of the entire market rather than just the largest firms. It also has the interesting characteristic that a market with many firms but a HI of, say, 0.25, will function similarly to a market with equally sized firms.

When the Department of Justice is considering whether or not to allow mergers, they look at the expected effect of the merger on the HI. If a merger will result in a large enough increase in the HI in a market, the merger will be examined more closely.

Four Market Structures and Their Characteristics

The four standard market structures considered in economics are

·  Perfect competition

·  Monopoly

·  Monopolistic competition

·  Oligopoly

There are some things to say about each, but one very important characteristic is the freedom with which firms may enter or leave a market. In perfect competition and monopolistic competition, firms can easily enter or leave the market. The result is that profits for a typical firm will be driven to zero in the long run. In monopoly and oligopoly, barriers to entry keep new firms out and can preserve large profits over a long period of time.

Perfect Competition

Perfect competition is an idealized market structure in which many firms produce identical goods (identical right down to the location at which they are sold), there is perfect information about prices and about the goods being sold and there are no barriers to entry. This is not descriptive of many markets in the real world, but it is a benchmark.

Under these conditions, each firm will take the market price as given and, in effect, will face a horizontal demand curve. This means that any one firm cannot raise its price, even slightly, or it will lose all of its customers.

If profits are positive in a perfectly competitive market, these positive profits will attract new firms to the business. The entry of new firms will increase supply and drive prices down. Entry will continue and the price will fall until it becomes unprofitable for new firms to enter. At this point, entry will cease and a typical firm in the market will earn zero economic profits.

Zero economic profits differs from zero accounting profits in that when a firm is earning zero economic profits it is just covering the cost of the business owner's time and is earning a fair return on its capital. While it may not be doing particularly well, it is making enough to keep it in business.

In long run equilibrium with zero profits, a typical firm can be described by the following diagram:

Long run price is equal to minimum average cost. Basically, this means that it is impossible for a typical firm to produce more cheaply than firms in competitive industries.

This has an important implication for vertical integration. If a company is buying an input in a competitive market, it is unlikely that they will be able to produce that input at a cost below the market price.

It may be the case that some firms in a competitive market have some sort of cost advantage which other firms cannot replicate. These firms would make positive economic profits, but these added profits would be more properly called a rent earned by their special advantage.

Monopoly

A monopoly is a market served by one firm facing a downward sloping demand curve and protected by significant barriers to entry. Because a monopolist faces no real competition, it is free to choose its own price with the understanding that higher prices will lead to a smaller quantity sold.

Of course, whether a market is really served by only one firm depends on how the market is defined. There may be only one grocery store on a block, but that is hardly an important monopoly in a city with hundreds of grocery stores.

While very few markets are actually served by only one firm, there are some characteristics of monopolies which are important in the real world.

First, for any firm protected by barriers to entry, positive economic profits can be maintained in the long run.

Second, when a firm has some choice as to what price it charges (as most firms will) selling additional units by lowering the price typically comes at the cost of revenues on units which would have been sold anyway.

Third, there is no guarantee that a firm will be operating at or near minimum average cost.

The implication for vertical integration is that if a firm is purchasing an input from a monopolist may be able to produce that input internally at an average cost lower than the price paid to the monopolist. The difficult consideration here, however, is that the monopolist is protected by some barrier to entry which may also prevent internal production.

Monopolistic Competition

Monopolistic competition describes a market in which there are many seller and free entry, but each seller has a product which is somewhat differentiated from other firms' products.

My favorite example of a monopolistically competitive market is the market for lunch in a busy business district or near a university. The barriers to entry are minimal, so if restaurants are making large profits new places will open and demand for each of the existing firms will fall. There will be many restaurants open for lunch, with each offering different dishes. Each restaurant knows that it can raise its price and lose some of the more fickle customers while maintaining its core group of patrons. Alternatively, each restaurant can lower the price or expand their menu and steal some business from other restaurants in the area.

There are two important ideas which come out of the analysis of monopolistically competitive markets.

The first is that in long run equilibrium profits will be driven to zero, but average cost will not be minimized. The implication is that if an input is being purchased from a firm which is monopolistically competitive, the supplier may not be profitable, but they may not be minimizing costs. However, as other firms' products become closer substitutes, the price paid may approach minimum average cost.