* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Download Economics of Strategy - Florida Gulf Coast University
Survey
Document related concepts
Revenue management wikipedia , lookup
Gasoline and diesel usage and pricing wikipedia , lookup
Darknet market wikipedia , lookup
Global marketing wikipedia , lookup
Grey market wikipedia , lookup
Marketing channel wikipedia , lookup
Market penetration wikipedia , lookup
First-mover advantage wikipedia , lookup
Product planning wikipedia , lookup
Marketing strategy wikipedia , lookup
Service parts pricing wikipedia , lookup
Dumping (pricing policy) wikipedia , lookup
Price discrimination wikipedia , lookup
Transcript
Economics of Strategy Market Structures and Dynamic Competition Substitutes and Cross-Price Elasticity • “In general, two products X and Y are substitutes if, when the price of X increases and the price of Y stays the same, purchases of X go down and purchases of Y go up.” • Individuals substitute continually • Economists measure this relationship with the “cross-price elasticity” Cross-Price Elasticity % change in the quantities of Y Ecp ------------------------------------------------------------ % change in the price of X How are the quantities sold in the market for automobiles affected by changes in the relative price of trucks? Products tend to be close substitutes when we observe… • same or similar product performance characteristics • same or similar occasions for use • same geographic market Product performance characteristics • subjective analysis of “similar” products so definition of the market becomes debatable • to reduce subjectivity, list the attributes which you believe are most influential in the consumers purchase decision • Difficult to say to what degree they are substitutes – Use cross-price elasticities • Role of transactions and transportation costs? Occasions for use • Where is the product used? • When is the product used? • How is the product used? Where? Geographic Market • Is the product sold by competitors where customers – are not affected by transportation costs • costs of time for the consumer to travel to an alternative location to purchase • costs of shipping the product to the customers location – are not affected by tax differences – convenience is not a major factor When is the product used? • Different demands during different hours, days, weeks, months, seasons – Golf Course prices in SW Florida – Phone services – Hotel/Motel accommodations How is the product used? • To listen to music… – – – – – – Radio CD Player Tape Player Eight…. No don’t go there MP3 Files Napster Problems in Identifying Substitutes • identifying precise product performance characteristics is subjective and imprecise • does not answer “how good a substitute is it?” – Use elasticity to solve this • Transaction or transportation costs can be influential • convenience can be influential but the price customers are willing to pay for it is subjective Defining Markets • “that set of suppliers and demanders whose trading practices establishes the price of a good” – George Stigler and Robert Sherwin • Do the firms constrain one another’s ability to affect price? Defining the Market • 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 other’s 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) Well-Defined Market • If the market is well defined, firms outside the candidate market will not be able to constrain the pricing behavior of those inside • A thought experiment: If all the firms inside the candidate market colluded, can they raise the price by at least 5%? If they can, the market is well defined Coca Cola’s Market • Is Coca Cola’s market, the market for cola drinks or the market for all potable liquids (including tap water)? • In the face of anti-trust concerns, Coke would have preferred the broader definition • Judicial system found the carbonated drinks market to be the relevant one Firm Elasticity or Industry/Market Elasticity? • Clearly differentiate – If I know the industry has a high cross-price elasticity it means that if industry prices rise people will substitute other products for my industries’ good or service – This tells us nothing about firm elasticity's within the industry, which is what firms are often interested in Geographic Competitor Identification • When a firm sells in different geographical areas, it is important to be able identify the competitor in each area • Rather than rely on geographical demarcations, the firm should look at the flow of goods and services across geographic regions Two-Step Approach to Identifying Geographic Competitors • First – Where do your customers come from (define the “catchment” area) • Second - Where do the customers in the catchment area shop? • With the technological innovations, the catchment area widens – Catalogue Sales – Internet Sales 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 Measuring Market Structure • A common measure of concentration is the N-firm concentration ratio - combined market share of the largest N firms • Herfindahl index is another which measures concentration as the sum of squared market shares • Entropy could be another measure of concentration – How fast do competitors disappear and appear? Herfindahl Index Structure Perfect Competition Monopolistic Competition Oligopoly Monopoly Herfindahl Index Usually < 0.2 Usually < 0.2 0.2 to 0.6 > 0.6 Intensity of Price Competition Fierce Depends on the degree of product differentiation Depends on inter-firm rivalry Light unless there is threat of entry Herfindahl Index • Rank all market shares from highest to lowest • Square all market shares and sum – Produces larger “penalties” for large market shares Market Structures • Handout – – – – Perfect Competition Monopolistic Competition Oligopoly Monopoly Market Structure and Dynamic Competitive Forces • A monopoly market may produce the same outcomes as a competitive market (due to the threat of entry) • A market with as few as two firms can exhibit fierce competition • Competition as Process – Schumpeter “the gale of creative destruction” – Von Hayek “How easy it is for the inattentive manager to allow profits to slip away” – Innovation and progress Perfect Competition • Assumptions – Many sellers who sell a homogenous product – Buyers and sellers are well-informed buyers (“perfect knowledge”) – Sellers can enter and exit freely – Often “large numbers of buyers and sellers” – but not always • Produces PRICE TAKERS where each firm faces a perfectly elastic demand Dynamic Condition - Zero Profits over the Long Run • Economic profits are driven towards zero due to entry and exit • Percentage contribution margin or per unit profits • PCM = (P - MC)/P – where P is price and MC is marginal • When profits are maximized PCM = 1/ – where is the elasticity of demand • Since is infinity, PCM approaches 0 in the limit Conditions for Fierce Price Competition • Even if these ideal conditions are not present, price competition can be fierce when – – – – There are many sellers The product is perceived to be homogenous Excess capacity exists Contestable Markets exist Many Sellers • With many sellers, collusive agreements become difficult to create and maintain • Cartels fail eventually because some players will be tempted to cheat because – Effective cartels raise prices and profits – Small cheaters may go undetected Price • Even if the industry PCM is high, a low-cost producer may prefer to set a low price • “Remember the Demand Curve” Davey Elasticity Crockett • Raises prices against anything but a perfectly inelastic demand curve means losing quantities Homogenous Products • Make for better substitutes! – Customers are more likely to price shop when the product is perceived to be homogenous – Hence, customer switching may be the largest source of revenue gain • this will create great interdependence in pricing and high levels of competition among firms in the industry Excess Capacity • When a firm is operating below full capacity it can price below average cost and operate with economic losses for some time period so long as the price covers variable costs • If industry has excess capacity, prices may 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 Contestable Markets • the viable threat of competition from interloper firms is enough to keep firms acting as if it had actual competitors. • Critical role of entry to dissipate profits • Low barriers to entry required • “Hit-and-Run” entry results Monopoly • The sole producer of a product for which there are no good substitutes • A monopolist faces little or no competition in its product market • A monopolist can set price – but is still subject to the demand curve • A monopolist profit maximizes – equilibrate marginal revenue and marginal costs – price on the demand curve • PRICE SEARCHERS Monopoly and Output • A monopolist perpetually under stocks the market and charges too high a price - Adam Smith • Price exceeds the competitive price • Price exceeds the marginal costs of production • Output is below the competitive level 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 Monopoly and Innovation, continued… • Monopolists are more likely to be innovative (relative to firms facing perfect competition) because they can capture some of the benefits of successful innovation • Since consumers also benefit from these innovations, they can actually be hurt in the long run if the monopolist’s profits are restricted Monopolistic Competition • There are many sellers and they believe that their actions will not materially affect their competitors • Each seller sells a differentiated product • Under monopolistic competition each firm’s demand curve is downward sloping rather than horizontal but it is very elastic for the firm – due to the availability of many close substitutes Vertical and Horizontal Differentiation • Vertically differentiated products unambiguously differ in quality • Horizontally differentiated products vary in certain product characteristics to appeal to distinct consumer groups – An important source of horizontal differentiation is geographical location Spatial Differentiation • Video rental outlets (or grocery stores) attract clientele based on their location • Consumers choose the store based on their “transportation costs” • Transportation or transactions costs prevent switching for small differences in price Spatial Differentiation • The idea of spatial location and transportation costs can be generalized for any attribute • Consumer preferences will be analogous to the consumers’ physical location and the product characteristic will be analogous to store location Spatial Differentiation • “Transportation costs” can be viewed as the cost of the mismatch between the consumers’ tastes and the product’s attributes • Products are not perfect substitutes for each other and for consumers some products are better substitutes than others – i.e., they have low “transportation costs” Monopolistic Competition • Many firms with non-interdependent price and quantity decisions • Many buyers • Low barriers to entry and exit • Close, but differentiated, substitutes – Burger King has a monopoly on “The Whopper” but there are many close substitutes Theory of Monopolistic Competition • An important determinant of a firm’s demand is customer switching – if products are viewed as close substitutes switching is more likely • Switching is less likely when – customer preferences are idiosyncratic – customers are not well informed about alternative sources of supply – customers face high transportation costs Theory of Monopolistic Competition 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 or how likely consumers are to switch Theory of Monopolistic Competition • 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 Monopolistic Competition and Entry • Since each firm’s demand curve is downward sloping, the price will be set above marginal cost • If price exceeds average cost, the firm will earn short run economic profit • But ease of entry with short run economic profits will attract new entrants until each firm economic profit is zero • Long run economic profit is zero Theory of Monopolistic Competition • 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 (where products are not well differentiated) the market mimics pure competition and the erosion of economic profits is rapid 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 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 firm’s output as given and chooses the output that maximizes its profits • The price that emerges clears the market (demand = supply) Cournot Reaction Functions 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 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 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 Bertrand Reaction Functions Bertrand Equilibrium • If the two firms are identical to begin with, they will be setting the same price • The price will equal marginal cost (same as perfect competition) since otherwise each firm will have the incentive to undercut the other 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 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 Bertrand Competition with Differentiation • When products are differentiated, price cutting is not as effective a way of stealing business • At some point (with prices still above marginal costs) reduced contribution margin from price cuts will not be offset by increased volume by customers switching 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 interindustry variation in price-cost margins (regulation, accounting practices, concentration of buyers and so on) Price-Cost Margins and Concentration • It is important to control for these extraneous factors if one need to study the relation between concentration and pricecost margin • Most studies focus on specific industries and compare geographically distinct markets Evidence: Concentration and Price • For several industries, prices are found to be higher in markets with fewer sellers – In markets where the top three gasoline retailers had 60% share, prices were 5 percent higher compared to markets where the top three had a 50% share – For service providers such as doctors and physicians, three sellers were enough to create intense price competition Economies of Scale and Concentration • Industries with large minimum efficient scales compared to the size of the market tend to exhibit 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 Concentration and Profitability • Concentration and profitability have not been shown to have a strong relationship • Possible explanations: – Differences in accounting practices may hide the differences in profitability – When the number of sellers is small it may be due to inherently unprofitable nature of the business