Download Competitors and competition

16/11/16
25E52000 Market Entry Strategies
for Entrepreneurial Business
Lecture 3
Competitors and Competition
Based on Chapter 5 in Besanko et al. (2013).
Economics of Strategy. Sixth Edition. Wiley.
Learning Objectives
—  Learn to identify competitors and analyse market
structures
—  Principal concepts
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Bertrand price competition model
Cournot quantity competition model
Direct and indirect competitors
Monopoly
Monopolistic competition
Oligopoly
Perfect competition
(Cross-)Price elasticity of demand
Real options
Stackelberg sequential move competition model
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Identifying Competitors
Competitors
—  If one firm's strategic choice adversely affects the
performance of another they are competitors
—  Competition can be either direct or indirect
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Direct: similar products and services for the same customer group
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Example: Audi and BMW
Indirect: different products and services that satisfy the same need
with the same group of customers
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Example: Audi and BMW versus public transport
—  In practice anyone who produces a substitute product is a
competitor
—  Measure of degree of substitution: cross-price elasticity of
demand
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Price Elasticity of Demand (PED)
PED = responsiveness of demand after a change in price
= % change in quantity demanded / % change in price
Uber’s Use of Price Elasticity of Demand
—  Uber uses dynamic pricing
—  At peak times, demand is less
price elastic
—  When there is more demand
(customers) than supply
(drivers), Uber raises the average
fare
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Cross-Price Elasticity of Demand
How price change in product B affects demand of product A?
Market Structures
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Market Structures
Perfect Competition
—  Many sellers who sell a homogenous good
—  Many well informed buyers
—  Consumers can costlessly shop around
—  Sellers can enter and exit costlessly
—  Each firm faces infinitely elastic demand
—  Economic profits go to zero
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Monopoly
—  A monopolist faces little or no competition
¡  No
close substitutes: buy it or do without
¡  Significant barriers to entry
—  ‘Price maker’
—  Inefficient allocation of resources
¡  Being a ‘price maker’ leads to higher prices than in
perfect competition
¡  Lower quantities of product sold in the market
Monopoly vs. Perfect Competition
—  Perfect competition
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Price takers
P=AR=MR=MC
—  Monopoly
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Price maker
Downward sloping demand curve
Lowering price the only way to
increase demand
Maximises profits when quantity is
set where MR=MC
MR < P > MC
Compared to perfect competition
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Price is higher
Quantity is lower
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Monopolistic Competition
—  Many sellers selling similar
but not identical products
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Vertical differentiation:
unambiguous performance/
quality differences
Horizontal differentiation:
certain product characteristics
appeal to different customer
groups
—  Demand is elastic
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Products are differentiated so
not perfect substitutes
But still close substitutes such
that if one firm raises its price
too high, many customers
switch to products made by
other firms
Monopolistic Competition
—  Short-run: supernormal profits are
possible
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Incumbent can behave like a monopolist
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Demand can be increased only by lowering
prices, affecting the price of all units sold
Thus, MR < P > MC
Example: the first fine-dining restaurant
in town
—  Long-run equilibrium: normal profits
¡  Low barriers to entry attract competitors
¡  Competition drives prices down (shifts
demand curve)
¡  Competitors enter until each firm’s economic
profit is zero
¡  Highly differentiated products: if entry does
not lower prices, entrants take away market
share from the incumbents
Innovation is a way from long-run back to short-run!
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Oligopoly
—  Small number of firms dominate
¡  Pricing and output decisions by each firm
affect the price and output in the industry
¡  Each firm’s decisions influence the profits of
the other firms
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Examples: McDonalds & Burger King; Airbus
& Boeing; Elisa, DNA & Sonera
—  Similar product: differentiation may or
may not exist
—  Significant barriers to entry
Oligopoly Models
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Oligopoly Models
—  Oligopoly models focus on how firms react to each other’s
moves
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Cournot (1835): each firm chooses the quantity to produce and
the resulting total quantity determines the market price
Bertrand (1883): each firm selects a price and stands ready to
meet all the demand for its product at that price
—  If the output cannot be increased quickly (capacity decision
is made ahead of actual production) Cournot competition is
the result
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Antoine Augustin
Cournot (1801-1877)
Applicable for long-run decisions
Homogeneous products
Market price results from total supply
—  If the firms can adjust the output quickly, Bertrand type
competition will ensue
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Applicable for short-run decisions
Firms satisfy all the demand (no capacity constraints)
Joseph Bertrand
(1822-1900)
Cournot Duopoly
—  Cournot (Nash) equilibrium is a pair of outputs Q*1
and Q*2 and a market price P* that satisfy three
conditions:
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P* is the price that clears the market: P* = 100 – Q*1 – Q*2
Q*1 maximises firm 1’s profits if it guesses Q*2 correctly
Q*2 maximises firm 2’s profits if it guesses Q*1 correctly
—  Each firm expects its rival to choose the Cournot
equilibrium output
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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 Duopoly
—  Paul and Jane compete in the local craft beer market
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Both have constant marginal cost of €10
Both have total cost equal to 10Q
Market demand: P = 100 – QPaul – QJane
Price decreases for each unit of additional (total) output
—  Both decide their production quantity at the same time
—  Both are willing to lower the price until all their beer is sold
—  Paul chooses QPaul to maximise profits taking QJane as given
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Paul ‘guesses’ how much Jane will produce – we assume Paul can guess
correctly
Paul’s output level is the best response to what he expects Jane to produce
—  Jane’s and Paul’s firms are identical, so the Cournot equilibrium is to
split the market 50-50
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at a level of QPaul = QJane that maximises both Jane’s and Paul’s profits
Cournot Duopoly
—  Paul maximises his profits (Jane’s function is a mirror image of Paul’s)
¡  ΠPaul = Revenue – Total cost = P*QPaul – TCPaul =
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(100 – QPaul – QJane)QPaul – 10QPaul =
100QPaul – QPaul2 – QPaul*QJane – 10QPaul
∂ΠPaul/∂QPaul = 100 – 2QPaul – QJane – 10 = 90 – 2QPaul – QJane
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Profit maximising QPaul: 90 – 2QPaul – QJane = 0; -2QPaul = -90 + QJane; QPaul = 45 – 0.5QJane
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—  Paul’s reaction function: QPaul = 45 – 0.5QJane
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If Paul thinks Jane will increase production, he will produce less in order to maximise
his profits
Jane’s problem is a mirror image of Paul’s
Solving both firms’ reaction functions simultaneously gives the best responses of Paul
to Jane (Q*Paul) and Jane to Paul (Q*Jane)
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Thus, Q*Paul=Q*Jane=30
P*=100-30-30=€40
Both Paul and Jane make a profit of €900
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P*Q – MC*Q = ([€40*30]-[€10*30]) = €900
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Bertrand Duopoly
—  Firms have sufficient capacity to produce any amount they
can sell
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Their task is to choose the profit-maximising price
While holding the rival’s price as fixed (based on their best guess)
—  If products are homogeneous
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The Bertrand model results in P=MC
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Because firms think that they can capture the whole market by
undercutting the rival’s price
—  If products are differentiated
¡  A price cut does not steal the whole market but only some of the
rival’s customers
¡  This discourages cut-throat price competition such as in the case of
identical products
Bertrand Duopoly
—  Customers view Paul and Jane’s beers as perfect substitutes
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Cournot equilibrium price was €40
Bertrand equilibrium price would be €10
If Paul sets his price at €39, he captures the whole market
So Jane has to match that price and has an incentive to cut her price
further to €38 to capture the whole market
÷  It follows that in the end, both set their price equal to MC = €10
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—  Customers view Paul’s and Jane’s beers as horizontally
differentiated
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Some customers like Jane’s beers more, others prefer Paul’s
If Jane cut her price, she could attract some of Paul’s customers but not
all of them, and vice versa
So price cuts are not as attractive a strategy as in the case of the beers
being perfect substitutes
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Bertrand Duopoly
PPaul
Jane’s reaction function
Paul’s reaction function
€18
€11
€19
€23
PJane
Stackelberg Model
—  Turns the simultaneous move game in Cournot
duopoly
—  Into a sequential move game where one party
commits to its quantity decision first
—  This constitutes a strategic commitment
—  Strategic commitments
¡  have
long run impact
¡  are hard to reverse
¡  can affect choices made by rivals by altering their
expectations
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Stackelberg Model
—  Modify the Paul and Jane Cournot duopoly model by allowing Paul to
decide his quantity first
—  How does Paul’s commitment change the outcome?
¡  Jane’s reaction function: QJane = 45 – 0.5QPaul
¡  If Paul decides first, Jane doesn’t have to guess Paul’s quantity – she knows it
¡  Having the same reaction function, Paul knows Jane’s
¡  So Paul knows exactly how much Jane will produce, in response to any QPaul
¡  Paul’s choice of QPaul thus determines total quantity and market price
¡  Paul can maximise his profits by choosing QPaul = 45
¡  This changes the profits such that instead of each earning €900 as in the Cournot
case
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Paul earns €1012.50
Jane earns €506.25
—  By committing to produce 45 instead of 30 units, Paul forces Jane to
cut back her production to 22.5 units – and increases his profits
Stackelberg Model
—  Paul can maximise his profits by choosing QPaul = 45 based on the
following information
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Price: P = 55 – 0.5QPaul
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P = 100 – (QPaul + QJane) = 100 – [QPaul + (45 – 0.5QPaul)] = 100 – 45 –
QPaul + 0.5QPaul = 55 – 0.5QPaul
Profit: ΠPaul = P(QPaul) – 10QPaul = (55 – 0.5QPaul)QPaul – 10QPaul
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Setting the derivative of the profit function with respect to QPaul equal to
zero gives the profit maximising QPaul = 45
—  Jane’s response: QJane = 45 – 0.5(45) = 22.5
—  Market price: P = 100 – QPaul – QJane = 100 – 45 – 22.5 = €32.50
—  Profits:
¡  Paul: P(QPaul) – 10QPaul = 32.5(45) – 10(45) = €1012.50
¡  Jane: P(QJane) – 10QJane = 32.5(22.5) – 10(22.5) = €506.25
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Real Options
—  The value of commitments lies in creating
inflexibility
—  However, when there is uncertainty
¡  Flexibility
is valuable since future options are kept open
¡  Commitments can sacrifice the value of the options
—  A real option exists if future information can be
used to tailor decisions
¡  Better
information about demand can be utilised by
delaying implementation of projects
¡  Value of real options may be limited by the risk of
preemption
Real Options: Example
—  Jane wants to expand the availability of her beers to
another city
—  In order to do that, she needs to invest €100K to
production capacity
—  She forecasts two equally likely scenarios for the net
present value (NPV) of cash flows from the investment
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Wide product acceptance: €300K
Low product acceptance: €50K
—  If Jane invested now, the expected NPV of the
investment would be
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0.5(300) + 0.5(50) – 100 = €75K
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Real Options: Example
—  By waiting one year, Jane would know which scenario arises
¡  Assume NPV of alternative investment is 0
¡  The discount rate for waiting a year is 10%
—  Wide product acceptance
¡  During the year, a competitor has taken some of the market and the NPV
of the investment has reduced to €200K
¡  Even if Jane could anticipate it, she should still wait and invest a year
later
¡  Because her NPV of €91K is higher than the NPV of immediate
investment (€75K)
÷  [0.5(200) + 0.5(0)]/(1.10) = €91K
—  Low product acceptance
¡  Jane would not invest at all
¡  So she would avoid a potential loss by waiting
IT’S QUIZ TIME!
(IF WE HAVE TIME)
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