Download BSL 2: Strategic environment - Competition

Business Strategy for Lawyers
Chapter 2:
The strategic environment
(competition)
Prof. Amitai Aviram
[email protected]
University of Illinois College of Law
Copyright © Amitai Aviram. All Rights Reserved
S14D
The strategic environment (competition)
Overview of Chapter 2
a) Economics of competition
– Static analysis: supply & demand curves
– Dynamic analysis: changes in supply & demand
– Market power & constraints on pricing
b)
c)
d)
e)
2
Substitution
Entry
Rivalry
Supply chain
© Amitai Aviram. All rights reserved.
Economics of competition
Welcome to business hell…
To understand competition, start in business hell:
Perfect competition & marginal cost pricing
3
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Economics of competition
The concept of marginal cost
• Marginal cost (MC): cost of producing the next unit of the product
• Example
–
–
–
–
4
Producing one widget requires 1 person to work for 1 hour to assemble it
Wage: $4/hour
Raw materials: another $1/widget
Widgets
Total
Marginal
Overhead cost: $3, regardless of
Produced
Cost
Cost
# of widgets produced (this could
be rent, management costs, etc.)
0
$0
$8
1
$8
$5
2
$13
$5
3
$18
$5
4
$23
$5
5
$28
© Amitai Aviram. All rights reserved.
Economics of competition
How low can you price?
• You are a widget producer in a competitive market
• To get customers to buy your widgets, you must offer them the
lowest price possible
• Of course, you can’t offer a price
so low that you’ll be better off not
Widgets
Total
Marginal
Produced
Cost
Cost
producing the widget
• So, how low can you price?
0
$0
$8
5
1
$8
$5
2
$13
$5
3
$18
$5
4
$23
$5
5
$28
© Amitai Aviram. All rights reserved.
Economics of competition
How high can you price?
• We now know how low a firm can sell
its product
• But most firms are in business to earn
as much as they can
• How high can the widget producer
price its widgets?
– Assume the market is perfectly
competitive (many firms identical to
yours)
6
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Economics of competition
Profitability in competitive market
• In a perfectly competitive market, P=MC
• Suppose market price (P) is $5 (equal to MC):
Widget Output
(Q)
Marginal Cost
(MC)
Total Cost
((MC*Q)+3)
Total Revenue
(P*Q)
Profit (Loss)
(T. Rev. – T. Cost)
4
$5
$23
$20
($3)
5
$5
$28
$25
($3)
6
$5
$33
$30
($3)
• When will the firm be profitable?
• Is there a reason to expect that market price would be higher than
$5?
7
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Economics of competition
The supply curve
• The supply curve shows the aggregate
(market-wide) supply
of a product at a given price
– I.e., how many units of the product would
be produced by all firms, if they could sell
at that price
– Since firm produces if P≥MC, curve tracks
the aggregate MC in the market
Price
(P)
Supply curve
of our example
(blue)
5
• Supply curve in our example
– All firms had the same MC, so the supply
curve was flat
8
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Quantity (Q)
Economics of competition
The supply curve
• But in the real world:
– Different firms have different MCs
– MC changes for the same firm as it
produces a different quantity
• Typical “real world” supply curve
Price
(P)
– Slopes downwards at first, as scale &
experience improve the efficient use of
resources
– Then slopes upwards as costs rise
• Costs rise as resources are overused, or
less efficient resources are used
• Lowest-MC firms form the beginning of
the supply curve, but costs rise as
efficient firms reach their production
capacity, higher-MC firms can sell,
pushing the curve upwards
9
Typical “real world”
supply curve (gray)
5
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Quantity (Q)
Economics of competition
The demand curve
• The demand curve shows
the aggregate demand for
the product at a given price
• Demand curves typically slope
downwards
Price
(P)
Demand curve
(red)
– What causes the reduction in demand
as prices rise?
Quantity (Q)
10
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Economics of competition
Measuring demand
• Self-elasticity of demand:
degree to which an increase
in price reduces demand
– % change in quantity demanded in
response to a 1% change in price
– AKA price sensitivity
Price
(P)
11
P=11-Q
(red)
• E.g., hypo demand curve: P=11-Q
– A decrease of $1 in price increases
demand by one unit
– At P=$5, 1% P increase (to $5.05) lowers
Q to 5.95 (-0.05; -0.83% of 6)
– So, at P=$5, Ed=-0.83
11
5
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6
11
Quantity (Q)
Economics of competition
Self-elasticity of demand
• On one extreme is a perfectly
elastic demand, such as P=5
– Ed=-∞
– Customers will buy an infinite
amount of the product at a price of
$5, but will not buy even a single
product at a higher price
• What can cause this elasticity?
Price
(P)
11
5
Perfectly elastic
demand (blue)
6
11
Quantity (Q)
12
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Economics of competition
Self-elasticity of demand
• On the other extreme is a perfectly
inelastic demand, such as Q=6
– Ed=0
– Customers will buy 6 units at any
price, but will not buy even a single
additional product, no matter how
low the price drops
• What can cause this elasticity?
Price
(P)
Perfectly inelastic
demand (green)
11
5
6
11
Quantity (Q)
13
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Economics of competition
Self-elasticity of demand
• Self-elasticity is measured empirically
• However, major factors affecting it can be used as proxies (examples,
reducing elasticity):
– No close substitute / product not commoditized
• E.g., famous artist’s painting, books, movies
– Necessary purchase
• E.g., life-saving medicine
– Price is not salient to customers
• E.g., restaurant menu
– Purchase quantity/bundle not fixed
• E.g., selling in smaller boxes instead of raising prices
• Harder to compare prices & to notice price changes
14
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Economics of competition
Self-elasticity of demand
Real-world self-elasticity figures (source: Wikipedia)
• Cigarettes: -0.3 to -0.6 (general); -0.6 to -0.7 (youth)
• Alcoholic beverages
– -0.3 or -0.7 to -0.9 (beer); -1.0 (wine); -1.5 (spirits)
• Airline travel: -0.3 (first class); -0.9 (discount); -1.5 (pleasure travelers)
•
•
•
•
15
Oil (world): -0.4
Car fuel: -0.25 (short run); -0.64 (long run)
Medicine: -0.31 (medical insurance); -.03 to -.06 (pediatric visits)
Transport: -0.20 (bus travel); -2.80 (Ford compact automobile)
© Amitai Aviram. All rights reserved.
Economics of competition
Intersecting supply & demand



Assume demand curve is: P=11-Q; supply curve is P=5
In perfect competition, market price
is where supply & demand curves
Price
intersect (Here, at: P=$5, Q=6 units)
(P)
Demand curve
Market power (“MP”)
11
(red)



The ability of a firm (or group of firms) to
charge >MC (i.e., above supply curve)
Another definition of MP: ability to affect
market price or market output
The more MP, the greater the firm’s
freedom to raise prices
Supply
curve
(gray)
6
5
56
11
Quantity (Q)
16
© Amitai Aviram. All rights reserved.
Economics of competition
Intersecting supply & demand

Even if firm has MP, it is constrained by the demand curve:
higher P means lower Q


Here, if firm can charge $6,
then P=$6, Q=5 units
Higher self-elasticity means
MP is less profitable
Price
(P)
11
Supply
curve
(gray)
Demand curve
(red)
6
5
56
11
Quantity (Q)
17
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Economics of competition
Dynamics: changes in demand



A demand increase (demand curve
shifts to the right) means that the
value customers receive from the
product has increased
 Note: cause of demand increase is
separate from issue of product’s
price
If demand increases, quantity & prices
rise
Likewise, if demand decreases (value
from product is reduced), both prices
& quantity fall
Price
(P)
Demand curve
Red: P=11-Q
More D - Green: P=13-Q
Less D - Blue: P=9-Q
11
6
5
4
5 67
11
Quantity (Q)
18
© Amitai Aviram. All rights reserved.
Economics of competition
Dynamics: changes in supply



A supply increase (supply curve shifts
to the right) means that the quantity
producers can produce at a given MC
has increased
 I.e., increasing capacity
 Note: again, this is unrelated to
the product’s price
If supply increases, quantity rises &
price drops
Likewise, if supply decreases (less Q
produced at a given MC), quantity falls
& prices rise
Price
(P)
11
6
5
4
567
11
Quantity (Q)
19
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Economics of competition
Dynamics: cyclical markets

Some changes in supply/demand are unintentional, but many are
intentional


E.g., increase supply by building a new factory/expanding existing
factory; or increase demand by using product for more things than
before
Intentional changes are often driven by prices


But in some markets, there’s a lag between the decision to increase
supply/demand & the actual increase


20
E.g., if P goes down, customer may use product for more things; if P goes
up, producer may expand capacity
E.g., takes years to develop a new mine
Result: mismatches between supply & demand
© Amitai Aviram. All rights reserved.
Economics of competition
Dynamics: cyclical markets

Example: supply-driven cycle

Demand increases



Producers expand capacity



Build/expand mines
Since new capacity takes years
to come on-line, shortage persists
New capacity comes on-line


21
E.g., new industry requires copper
P rises & Q rises (high profitability)
P drops & Q rises (profit down)
Many capacity expansion plans still in progress – expensive to cancel, but
the excess capacity pushes prices down for long time
© Amitai Aviram. All rights reserved.
Economics of competition
Dynamics: cyclical markets

Cycle continued

Profitability very low




Demand increases again



22
But for years producers haven’t expanded capacity, so can’t respond to
demand quickly
Shortage; prices rise quickly
Producers expand capacity


Firms go bankrupt (some capacity lost)
Other firms can’t afford to expand capacity
Excess capacity disappears
And so on…
Should a producer avoid expanding capacity when a shortage occurs?
© Amitai Aviram. All rights reserved.
Economics of competition
Dividing the value pool – No MP
• Customer surplus is the value of the
product to the customer less the price
the customer paid
Price
(P)
11
– When firms can only charge one price from
all customers, all customers except for the
marginal one have some surplus
Demand curve
(red)
Supply curve
(blue)
Customer
surplus
• Producer surplus is the price the
customer paid less the marginal cost of
the product to the firm
5
Total cost &
total revenue
6
23
11
Quantity (Q)
– If firms have no MP (i.e., competitive
market in which all firms have same MC),
there is no producer surplus
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Economics of competition
Dividing the value pool – With MP
• If MC=$5, but P=$6, then:
– Fewer units produced & sold (6→5)
– Customer surplus lower ($18→$12.5)
Price
(P)
• One fewer widget to enjoy
• Surplus from each purchased widget is
$1 lower (because widgets cost $1 more)
11
– Total revenue is unchanged: $30
Customer
surplus
6
5
• Was 6x$5; now 5x$6
Prod. surplus
– But total costs lower ($30→$25)
• Because fewer widgets are produced
Total cost
5 6
24
11
Quantity (Q)
– Remaining $5 are the producer surplus
(profits)
© Amitai Aviram. All rights reserved.
Economics of competition
Value as a pricing constraint
•
In the last example (value pool – with MP) we assumed that firm
could charge $1 above MC; but how much above MC can firms
actually charge?
Consider an absolute monopolist
•
–
•
No competition to undercut your prices!
–
–
25
Assume that Congress passed a law that grants your firm (a widget
manufacturer) a monopoly in manufacturing & selling widgets in the U.S., and
that bans widget importing
Suppose that MC=$5
Should you charge $6? $6,000? $6M?
© Amitai Aviram. All rights reserved.
Economics of competition
Value as a pricing constraint
• Goodbye marginal cost pricing…
– Monopolist’s price cannot be undercut by competitors
– Therefore, the monopoly will raise its price above MC
• But there’s another constraint: higher price, lower demand
– As P rises, Q drops (P>product’s value to customer)
– Note: Monopolist can determine P or Q, but not both
• Hello marginal revenue pricing…
– Firm will increase P to point that its profits are maximized (i.e.,
point where additional revenue from an increase in P is lower
than the lost revenue from decrease in Q)
• Revenue = P x Q
26
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Economics of competition
Marginal revenue pricing
• Example: Going back to the widget market, we use the demand function: P=11-Q
(MC=$5, overhead costs = $3)

27
Widget
Output
(Q)
Marginal
Cost
(MC)
Total
Cost
Price
(P=11-Q)
Total
Revenue
(P*Q)
Marginal
Revenue
(TRQ+1-TRQ)
(MC*Q+3)
1
$5
2
Profit
(T. Rev-T. Cost)
$8
$10
$10
$8
$2
$5
$13
$9
$18
$6
$5
3
$5
$18
$8
$24
$4
$6
4
$5
$23
$7
$28
$2
$5
5
$5
$28
$6
$30
$0
$2
6
$5
$33
$5
$30
$-2
$-3
7
$5
$38
$4
$28
Total revenue is maximized when marginal revenue = marginal cost
© Amitai Aviram. All rights reserved.
$-10
Economics of competition
Supply reduction & deadweight loss
Price
• Monopolist restricts output (6→3), in
order to raise price ($5→$8), to the point 11
where it maximizes profits ($0→$9, or $3→$6 after overhead)
8
• Note the red triangle: it represents lost
sales to customers who would have
5
bought at $5, but won’t at $8
– Would it be profitable to sell additional
widgets to those customers?
– Why doesn’t the monopolist sell to them?
28
© Amitai Aviram. All rights reserved.
Cons.
Surplus
Producer
Surplus
Total
Cost
3
6
11
Quantity
Economics of competition
Measuring MP
• So, price ranges from MC in perfect competition to the monopoly
price (price that makes MR=MC) in a monopoly, depending on how
much MP the firm has
• But how do we measure MP?
– Can we measure MP by observing how much the price exceeds MC?
• MP is like the wind – in itself it is invisible; we can only know of its
existence by observing its consequences (e.g.,
a breeze hitting our face, leaves whirling in the air)
• Can we identify MP by changes in prices/output?
29
© Amitai Aviram. All rights reserved.
Economics of competition
Measuring MP
• Example 1
– A significant cost in manufacturing widgets is the cost of oil, which fuels widgetproducing machines
– Oil has doubled in price in the past year; widget prices increased by 50%
– People buy fewer widgets, reducing the number of widgets produced
– Widget prices went up, output went down. Does this prove that widget
manufacturers have MP?
• Example 2
– Springfield Nuclear Power Plant has always
been the only electric company in Springfield
– SNPP never raised its prices above the rate
of inflation. Does this prove that SNPP has
no MP?
30
© Amitai Aviram. All rights reserved.
Economics of competition
Measuring MP
• Since we usually can’t identify MP just by observing prices & output,
we need a tool to identify whether a firm possesses MP
– This tool is competition analysis
• Competition analysis begins with a few (unrealistic) assumptions that,
if true, indicate firm has absolute MP
– It then examines how far the actual situation is from each assumption; the
closer reality is to the assumptions, the more MP the firm has
31
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Economics of competition
The forces that shape competition
•
If the following assumptions were correct, a firm would have
maximum MP:
1.
2.
3.
4.
•
32
No substitution: customers can’t substitute to another product that
responds to same needs
No entry: other firms can’t adjust to offer the product
No rivalry: firm is the only one offering the product
No buyer/supplier power: suppliers’ & customers’ markets are
perfectly competitive
Since these assumptions are never entirely correct, each of these is
a force we need to evaluate to assess competition (i.e., how much
of VP is allocated to firms in our market)
© Amitai Aviram. All rights reserved.
The strategic environment (competition)
Overview of Chapter 2
a) Economics of competition
b) Substitution
– Cross elasticity of demand
– Proxies for cross-elasticity
– Refining the substitution analysis
c) Entry
d) Rivalry
e) Supply chain
33
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Cross-elasticity of demand
Compared to self-elasticity
• Substitution is measured by assessing the cross-elasticity
(“X-elasticity”) of demand
– Self-elasticity: the degree in which a rise in the price
of Product A decreases demand for Product A
• Affected by substitution (to all other products) & value
– X-elasticity: the degree in which a rise in the price of
Product A increases demand for Product B
• Affected by substitution to a specific product
34
© Amitai Aviram. All rights reserved.
Cross-elasticity of demand
Examples
• High X-elasticity: Exxon gasoline & BP gasoline
– If Exxon & BP gas stations are similarly accessible, an increase in Exxon’s price
will cause some drivers to buy gas from BP, increasing demand for it
• Moderate X-elasticity: (RTE) cereal & hot cereal
– If the price of ready-to-eat cereal increased, some people will buy other
breakfast foods instead; some will choose hot cereal, increasing demand for it
• Low X-elasticity: Dogs & hot-dogs
– Increase in the price of hot dogs will make some people opt for other foods
– But a consumer who decides a hot dog is too expensive is unlikely to
use the money to buy more dogs
Exxon/BP
Gasoline
RTE/Hot
Cereals
• McDonald’s & Burger King?
• McDonald’s in NE Urbana & Burger King in Savoy?
• Summer clothes in spring & summer clothes in fall?
35
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Dogs/
Hot Dogs
Cross-elasticity of demand
Geographic & temporal effects
• X-elasticity is affected by functional distinctions, but also by
geographical & temporal distinctions
• Geographic distinctions
– McDonald’s in NE Urbana & Burger King in Savoy
– Jewelry store in NE Urbana & jewelry store in Savoy
– When does geography matter?
• Temporal distinctions
– Summer clothes in spring & summer clothes in fall
– Watermelon during the season & watermelon off-season
– When does time matter?
36
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Cross-elasticity of demand
Why is it useful?
Coke
Pepsi
Cola beverages
Sprite
Carbonated beverages
Non-alcoholic beverages
All beverages
37
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Water
Beer
Cross-elasticity of demand
Why is it useful?
Coke
Pepsi
Cola beverages
Sprite
Carbonated beverages
Recreational (“party”) beverages
Beer
Water
All beverages
How can we determine which view is correct?
I.e., which is the closer substitute to Coke – beer or water?
38
© Amitai Aviram. All rights reserved.
Cross-elasticity of demand
Using cross-elasticity
• How much X-elasticity is the threshold to be “in the market”?
• To answer, think of the goal of market definition: to identify & assess
magnitude of MP
– So, for Product B to be in the same market as Product A means that Product B
serves as a check on the ability of a monopolist in Product A to exercise MP
(i.e., to profitably raise prices)
– So, we ask whether X-elasticity between A & B is sufficiently large that a
monopolist of A who increases the price of A (traditionally, by 5%) will lose so
many sales to B that its profits would decline (i.e., can’t exercise MP without
also controlling B)
39
© Amitai Aviram. All rights reserved.
Cross-elasticity of demand
Using cross-elasticity: example
Assumptions
Coke
Pepsi
Sprite
Beer
Sales ($)
100
100
100
100
X-elasticity
N/A
20
15
10
($ sales increase resulting from
5% increase in price of all
products to the left)
– Also assume profit margins are 90% (costs=10% of revenue)
• Round 1: Is Pepsi in the market?
–
–
–
–
Coke price up 5%; Coke’s lost sales: $20
Coke’s losses from lost sales: $18 ($20 x 90%)
Coke’s profits from price increase: $4 [(100-20) x 5%]
Coke lost $14; controlling all of Coke doesn’t give enough MP to make a 5%
price hike profitable
– Conclusion: Pepsi is in the market
40
© Amitai Aviram. All rights reserved.
Cross-elasticity of demand
Using cross-elasticity: example
Assumptions
Coke
Pepsi
Sprite
Beer
Sales ($)
100
100
100
100
X-elasticity
N/A
20
15
10
($ sales increase resulting from
5% increase in price of all
products to the left)
• Round 2: Is Sprite in the market?
–
–
–
–
Coke & Pepsi price up 5%; lost sales: $15
Losses from lost sales: $13.50 ($15 x 90%)
Profits from price increase: $9.25 [(200-15) x 5%]
Coke-Pepsi lost $4.25; controlling all of Coke & Pepsi doesn’t give enough MP to
make a 5% price hike profitable
– Conclusion: Sprite is in the market
41
© Amitai Aviram. All rights reserved.
Cross-elasticity of demand
Using cross-elasticity: example
Assumptions
Coke
Pepsi
Sprite
Beer
Sales ($)
100
100
100
100
X-elasticity
N/A
20
15
10
($ sales increase resulting from
5% increase in price of all
products to the left)
• Round 3: Is Beer in the market?
–
–
–
–
Coke, Pepsi & Sprite price up 5%; lost sales: $10
Losses from lost sales: $9 ($10 x 90%)
Profits from price increase: $14.50 [(300-10) x 5%]
Coke-Pepsi-Sprite gained $5.50; controlling all of Coke, Pepsi & Sprite gives
enough MP to make a 5% price hike profitable
– Conclusion: Beer is not in the market
42
© Amitai Aviram. All rights reserved.
Cross-elasticity of demand
Why use a 5% price increase?
• Antitrust regulators are concerned if MP allows firm to
profitably sustain a “small but significant, non-transitory
increase in price” (SSNIP)
– They consider 5% to be SSNIP
• You can replace that figure with whatever level of MP
you are interested/concerned about
– E.g., if you want to check what market needs to be
controlled to allow firm to raise prices by 50%, calculate
X-elasticity for a 50% price increase
43
© Amitai Aviram. All rights reserved.
Cross-elasticity of demand
The cellophane fallacy
• We found that a firm controlling Coke, Pepsi & Sprite has MP to raise
prices by 5%
– Suppose that Acme is the only producer of all three beverages. Naturally, it
chooses to raise prices by 5%.
• Acme then examines what would happen if it raised prices by
another 5%
– If it finds that it makes a profit from an additional price increase, it will increase
prices further
– If it finds that it loses money from an additional price increase, it will keep
prices where they are
• Result: Acme raises prices until x-elasticity with Beer is sufficiently
high to make a future price increase unprofitable
• If we look at x-elasticity at this point, would we say that Beer is in the
same market as Coke, Pepsi & Sprite?
44
© Amitai Aviram. All rights reserved.
Cross-elasticity of demand
The cellophane fallacy
• Called “cellophane fallacy” because it came up in an antitrust case
(U.S. v. duPont), that dealt with cellophane
• Solution to the cellophane fallacy:
– X-elasticity must be calculated not at the existing price level, but at the
price that would provide only normal profits
• But it is hard to calculate X-elasticity at fictitious prices
– Evidence on X-elasticity should be treated with greater skepticism a firm
has significant MP in the defined market
• If a firm is earning supra-competitive profits, the X-elasticity figures are
likely to be overstated (and thus other products will seem to be better
substitutes than they actually are)
45
© Amitai Aviram. All rights reserved.
The strategic environment (competition)
Overview of Chapter 2
a) Economics of competition
b) Substitution
– Cross elasticity of demand
– Proxies for measuring substitution
– Refining the substitution analysis
c) Entry
d) Rivalry
e) Supply chain
46
© Amitai Aviram. All rights reserved.
Proxies for substitution
Tools other than cross-elasticity?
• The advantage of X-elasticity as a market definition tool is that it can
be empirically measured
– Disadvantages of using X-elasticity to define markets?
• To overcome X-elasticity’s shortcomings, we need proxies for Xelasticity that can be used to:
– Narrow the list of products that are likely to be part of the same market (so we
can focus the X-elasticity analysis)
– Replace X-elasticity where data is unavailable or expensive to acquire
47
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Proxies for substitution
Baker, Market definition: an analytical overview
1.
2.
3.
Evidence of past buyer response to price change
Buyer surveys (of their expected response to price change)
Product/geography characteristics that matter to buyers
–
–
4.
Conduct of (supply-side) market participants
–
5.
E.g., extent to which firms track & respond to price changes or product
introductions of rivals
Views of market experts
–
48
E.g., shipping costs & geographical distribution of buyers
This is similar to our concept of customer benchmarks
More valuable if experts have access to primary information & if they base
costly business decisions on that information
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Proxies for substitution
Brown Shoe Co. v. U.S.
• Intended to detect a sub-market in a larger market
1. Industry recognition
–
Similar to Baker’s points 4 & 5
2. Product’s characteristics & uses
–
Similar to Baker’s point 3
3. Unique production facilities
–
–
What prevents manufacturer of product A from producing B?
Essentially tracks supply substitution (entry)
4. Distinct customers
5. Sensitivity to price changes
–
Similar to Baker’s points 1&2
6. Specialized vendors
49
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Proxies for substitution
Geroski & Porter
•
–
–
1.
2.
3.
•
–
Geroski, Thinking creatively about your market
•
•
•
•
50
Figure out how the need can be supplied (i.e., how a product can satisfy
customer benchmarks)
Is this a viable activity?
Consider demand, rivals, substitutes, etc.
Identify strategic necessity (minimum viable scale/scope)
Identify strategic options
To differentiate your product from rivals’ products
Porter, The five competitive forces
•
•
–
Defines market as viable ways to satisfy a need
Need + economic viability replace direct proxies for buyer substitution
Identify a need
Products are in same market if their market structure is similar
I.e., if the five forces operate on them in similar ways (similar buyers, suppliers,
barriers to entry, etc.)
Buyers, suppliers, entry, rivalry & substitution replace only substitution
(conflicts with Baker’s views)
Porter’s rule of thumb: Separate markets if activities differ in multiple forces
or differ significantly in ©any
one force
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Proxies for substitution
Summary
•
Direct evidence of buyer response to price change is the closest
proxy to X-elasticity, if future is expected to be similar to past & if
data is of good quality
Customer benchmarks (from basis of competition analysis)
Producer behavior (who do they track & respond to?)
•
•
–
•
Views of industry experts
–
51
But filter for producers’ PR incentives
If they have access to primary information & if they base costly business
decisions on that information
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The strategic environment (competition)
Overview of Chapter 2
a) Economics of competition
b) Substitution
– Cross elasticity of demand
– Proxies for measuring substitution
– Refining the substitution analysis
• Cluster markets
• Switching costs
• Current substitution threat
c) Entry
d) Rivalry
e) Supply chain
52
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Refining substitution analysis
Cluster markets
• Are left shoes & right shoes good substitutes?
– X-elasticity: If price of left shoes rises, do people buy more or less right shoes?
• Why do we have a shoe market (as opposed to left & right shoe
markets)?
• This issue comes up for many complementary products that are sold
as bundles
– E.g., Car market vs. markets for car engines, car bodies, steering wheels, etc.
– Why are these components always sold in a bundle?
– It gets more complicated when same customers buy both bundled &
unbundled products (e.g., wheels)
53
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Refining substitution analysis
Cluster markets
• Advantage of using cluster market
– Simplicity – if products almost always sold in a bundle, all products respond in
same way, so we treat them as one
• Problem with using cluster market
– Suppose dogs & hot dogs are considered one cluster market
– Acme has a 0 share of the $95 M dog market (sells no pets), but has an 80%
share of the $5M hot dog market
• In total, it has a 4% share of the dog & hot dog market
– Does Acme have MP under the cluster market definition?
– Does Acme have MP in reality?
54
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Refining substitution analysis
Switching costs
• Examples
– Gyms with childcare: Children get used to particular childcare service; insulates
gym from competitive pressures
– Cellphone exclusivity: If mobile phone service uses exclusive phones, switching
phone service requires buying a new phone
• Effect on the strategic environment
– Substitution: high switching costs reduce/eliminate substitution after customer
selects a particular product
– Entry: switching costs increase entrant’s costs to capture new customers, so
they reduce potential profits & require more time to reach MES (if economies
of scale are a BTE)
– Rivalry: reduces competition over existing customers (firms compete on new customers)
• Switching costs reduce rivalry more in mature markets (because mature
markets have fewer new customers)
• Increases impact of information asymmetries/marketing
55
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Refining substitution analysis
Current substitution threat
•
Once market is defined, identify the closest substitutes to your
“starting point” product
–
–
•
Degree of substitution with the closest rivals is:
–
–
56
Some products in market are greater substitution threat than others
Same measurements used to define markets are used to identify closest
substitutes (X-elasticity & its proxies)
An indicator of the current substitution threat
Identifies firms to focus on in rivalry & firm-level analysis
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Refining substitution analysis
Market definition: review
•
Pepsico v. The Coca-Cola Co.: Pepsi’s market definition: fountain
soda distributed by independent foodservice distributors (IFDs)
1.
2.
57
Is fountain soda a separate market from other soda?
Is soda distributed by IFDs a separate market from soda distributed via
bottlers?
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Refining substitution analysis
Market definition: review
• Is soda distributed by IFDs a separate market from soda
distributed via bottlers? Court: no
– IFDs provide more value, but bottlers can compete by price
• Are premium & value products in the same market?
– Coke does not have MP in distributing soda
• Of the cola syrup distributed to Coke’s top 50 restaurant accounts, Coke’s
company-owned outlets accounted for only 27.5%
– If soda via IFDs is a separate market from soda via bottlers, then
Pepsi & Coke aren’t rivals (at least regarding customers who use
IFDs)
• Since Pepsi used bottlers & Coke uses IFDs
58
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Substitution
Team project: market definition
• Each team should pick one establishment on campus that offers food
– Conduct research to define the market that centers on this establishment
– E-mail your team report to me (1 e-mail per team)
• Process of the project
1.
2.
Select a starting point (very narrow – one specific establishment)
Identify (based on evidence) the bases of competition
• Customer needs & customer benchmarks
3.
Substitutes
•
•
4.
•
Identify potential substitutes
Find evidence regarding the degree of substitution with your starting point
Conclusion: Which businesses are in the relevant market? Which are the
closest substitutes
For all evidence you use:
– Describe how it was collected
– Describe the evidence & its implication on your analysis
– Conduct a reliability assessment (weaknesses / blind spots of the data)
59
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The strategic environment (competition)
Overview of Chapter 2
a) Economics of competition
b) Substitution
c) Entry
– Economies of scale & scope
– Access to inputs & complements
– Imposing disproportional costs
d) Rivalry
e) Supply chain
60
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Entry
Types of BTE
• Key question regarding entry: If a firm’s product is
profitable, why aren’t other firms copying the firm?
• Common reasons:
– Economies of scale & scope
– Access to inputs & complements
– Other actions that impose disproportional costs on rivals
61
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Economies of scale & scope
What are economies of scale?
• Economies of scale (in supply): cost per unit drops as production
increases
• Measuring cost per unit
– Variable costs (VC): costs that vary w/quantity produce
• E.g., raw materials, hourly wages for labor
– Fixed costs (FC): costs that don’t vary w/quantity produced
• E.g., rent, administrative costs
– Marginal cost (MC): cost of producing next unit (next unit’s VC + new FC)
– Average variable costs (AVC) = Total VC/Q
• Cost of past, not future, units
• Does not include marginal FC
• Sometimes used as a proxy for MC
– Average total cost (ATC) = (Total FC + Total VC)/Q
• Cost of past, not future, units
• Includes all FC, not just marginal ones
62
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Economies of scale & scope
Common causes of supply-side economies
• High FC compared to VC
– FC can be spread over more units if production increases
– Example: Production of steel involves large changes in temperature (from room
temperature to very hot). Heating and cooling must be gradual, or the
machinery will break. Therefore, turning production on or off requires hours of
warming up/cooling down. Since most of the cost of production is energy for
the machines & wear on the machines (which will occur anyway), might as well
spend the raw materials and make the product.
• Experience/learning curve
– Employees get better at what they do
– Find ways to improve production process & product design
63
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Economies of scale & scope
Example
• You are a widget producer; market price for widgets is $6
• Producing a widget:
– 1 employee operating 1 machine takes 1 hour to produce a widget
• Employee’s wage: $4/hour
• Machine is wind-powered – no energy costs
– Raw materials cost another $1 per widget
– Rent for the factory is $10/day (regardless of # of widgets produced)
• How much is the AVC?
• Based on these assumptions, how many units do you need to
produce to minimize ATC?
64
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Economies of scale & scope
Example: add capacity constraints
• It is only windy 4 hours/day
– The rest of the day you can’t use your machines
• Factory only has room for 5 machines
– So, wind-powered machines in your factory can produce up to 20 widgets/day
• To produce more than 20 widgets/day, employees must produce
them manually
– This takes longer: 2 hours per widget
• How much is the AVC for manual production?
• With market price @$6, firm maximizes profits @ 20 widgets
– Above that, it loses $3 on each widget sold ($6-$9)
• Quantity in which ATC is lowest is called Minimum Efficient Scale
(MES) or Minimum Viable Scale (MVS)
65
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Economies of scale & scope
Example
20
15
10
5
0
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26
-5
-10
-15
Profit
66
Avg. TC
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Economies of scale & scope
Impact on entry
• MES impacts the feasibility of entry into a market
– If you can’t get your market share up to the MES, then you’ll have higher
production costs than rivals & gradually lose sales to rivals
• Example
– In our hypo, MES is 20 widgets
– Assume that total demand for widgets is 18 & Acme currently supplies the
entire demand
– Ajax expects to “capture” orders for 4 widgets
• Ajax’s costs: $10 + 4x($1+$4) = $30 ($7.50/widget)
• Acme’s costs: $10 + 14x($1+$4) = $80 ($5.71/widget)
– Ajax will lose if it prices below $7.50; Acme can price much lower, so it can
capture back the 4 widget orders by offering a price below $7.50
67
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Economies of scale & scope
Impact on entry
• Analogy to climbing up a slippery slide
– Slide length: MES / entrant’s initial sales
• If 100% or less, no problem for entrant
• If over 100%, entrant needs to capture additional sales to equalize costs
• Particularly significant when switching costs are high (e.g., long-term contracts)
– Slide steepness: ATC @ entrant’s initial sales / ATC @ MES
• When entrant reaches MES, this is 100%
• Amount in excess of 100% represents entrant’s
cost disadvantage compared to incumbent who
already reached MES
• How can a firm that operates below MES survive?
68
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Economies of scale & scope
Surviving below MES
1. Find a niche (differentiation)
–
Consider earlier hypo, but add:
•
•
–
–
–
Acme is in Chicago; Ajax locates itself in Champaign
There’s a $3/widget transportation cost
For Acme, selling a widget in Champaign has MC of $8
($4 labor, $1 raw materials, $3 transportation)
Ajax’s ATC is $7.50, so Ajax captures sales in Champaign
Note: entrants (like Ajax) consider whether they can sell above ATC;
incumbents (like Acme) consider whether they can sell above MC (or AVC),
because they already spent the fixed costs
2. Displace the incumbent (confrontation)
–
If customers are swayed just by price & Ajax has enough cash to burn, it can
price @ $5.56 (ATC @18 units), which is below Acme’s ATC ($5.71) – once it
captures more customers than Acme, it has lower costs & Acme might be
pushed out of the market (or forced to share it)
3. Bring antitrust suit/regulatory action (confrontation)
69
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Economies of scale & scope
Surviving below MES
4. Reach an understanding to respect each firm’s turf (coordination)
–
May violate antitrust laws
5. Grow the market (value pool)
• If Ajax can increase total demand by 10, it will have 14 & Acme will
have 14 (so their costs will be the same)
• But what stops Acme from stealing the new customers?
– Differentiation/coordination/confrontation
– Costs beyond MES
• Costs start rising when producing above the MES; when they exceed costs of
firms producing below MES, a small firm can survive below MES
• Example
– Assume total demand is 34
– If Ajax sells 14, ATC=$5.71; Acme then produces 20 widgets, w/ATC=$5.50
– If Acme produced widget 21 manually then MC=$9, so Acme won’t try to sell it
for less than $5.71 & push Ajax down to 13 widgets
70
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Economies of scale & scope
Costs beyond MES
• What happens to costs beyond MES affects market structure
71
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39
37
35
33
31
29
27
25
23
21
19
17
15
13
9
11
5
39
37
35
33
31
29
27
$5.00
25
$5.00
23
$5.50
21
$5.50
19
$6.00
17
$6.00
15
$6.50
13
$6.50
9
$7.00
11
$7.00
7
$7.50
5
$7.50
7
– If costs climb steeply beyond MES (as in hypo & red graph below), larger firms
won’t grow much above MES; small firms capture niches
– If costs climb mildly beyond MES (as in blue graph below), firms will tend to
grow above MES; small firms are unlikely (unless price is less important than
other bases of competition)
Economies of scale & scope
MES & number of rivals
• Number of firms in the market is influenced by the ratio: MES/total
demand
– If ratio ≥ 100%, market is a natural monopoly (only 1 firm likely to survive)
– If 100% ≥ R ≥ 50%, no more than 2 firms likely to survive
• 1 firm, if costs don’t rise much above MES (e.g., blue graph)
– If 50% ≥ R ≥ 33%, no more than 3 firms likely
• 1 or 2 firms, if costs don’t rise much above MES
– If 33% ≥ R ≥ 25%, no more than 4 firms likely
– Etc. …
72
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Economies of scale & scope
Economies of scale in demand (NW effects)
• Until now we considered economies of scale in supply
• Economies of scale can also exist in demand (in which case they are
called network effects), if the value to a user of the product increases
as other’s use of the product increases
• Example 1: phones
– A telephone is useless if only one person uses it
– Benefit increases the more people have a phone
• Example 2: credit cards
– If more people carry a given credit card, more merchants will accept it
– If more merchants accept a card, more people want to carry that card
– Each additional cardholder benefits all existing cardholders & merchants
affiliated with that credit card brand
73
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Economies of scale & scope
Economies of scale in demand (NW effects)
• Example 3: electric cars & charging stations
– Presence of charging stations increases the value of owning an electric car;
presence of additional electric cars increases profitability of a charging station
• Examples 2 & 3 exhibit indirect network effect: additional use of one
product spurs demand for a complementary product
– Such effects are common in multi-sided platforms (MSPs): products that allow
direct interaction between 2 or more types of customers
– E.g., credit cards (shoppers <-> merchants); newspapers (readers <-> advertisers)
• Do these have network effects?
Facsimiles
74
Online markets
Word Processors
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Soda Dispensers
Economies of scale & scope
Economies of scale in demand (NW effects)
• Almost every market has some network effects, because almost every
product has complements (e.g., product & distribution of the product)
• Factors that make network effects a significant BTE include:
–
–
–
–
Difficult to quickly create/expand rival networks (cf. soda dispensers)
High added value from complement (cf. word processing without file-sharing)
High switching costs between networks
Member can’t be on multiple networks (cf. gas stations)
• Aggregators can facilitate multi-network membership (e.g., Orbitz)
– Centralized control of the network (cf. open access standards)
• Network effects as a BTE
– Entrant disadvantaged if not part of large (existing) network; example:
•
•
•
•
75
QWERTY keyboard (c. 1868) designed to minimize jamming of type bars
Dvorak keyboard (1936) designed to maximize typing speed
Paul David (1985) cites this as an example of network effects as BTE of a superior standard
Liebowitz & Margolis (1990) present a murkier picture; not clear which standard is superior
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Economies of scale & scope
Economies of scope
• Economies of scope in supply
– ATC drops if several products produced by same firm/plant
– E.g., multiple sections in a newspaper; producing petrochemicals when refining oil
– BTE: costs higher for an entrant who doesn’t produce both products
• Economies of scope in demand
– Value increases if several products are purchased together
– Examples: one-stop shopping; buying car body & car engine from same firm
– BTE: lower value to product of entrant who doesn’t offer both products
• Producer can either make both products, or make one & get access to the other
(e.g., buying engines from a supplier; sharing a store with another retailer)
76
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Entry
Access to inputs & complements
• Inputs are raw materials/services required to produce a product
• Complements are products consumed together with other products
– Example: tablet & cellphone network access
– Example: gas & gas retailing at a station
• Quantitative test for whether C is a complement
– Assume that the price of C increased by 10%
– If demand for A decreased – C is likely a complement
– If demand for A increased – C is likely a substitute
• Inputs/complements include (non-exhaustive list):
–
–
–
–
–
–
77
Distribution of a product
Capital (ability to get funding for the business)
Product’s branding/image (therefore, product differentiation creates a BTE)
Land in a particular location (matters particularly in retailing, hotels, etc.)
Proprietary technology & know-how used to make the product
Legal right to provide the product (so law/regulation can be used as a BTE; e.g.,
zoning laws, professional licensing regulations, health/safety regulations)
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Entry
Access to inputs & complements
• Access to inputs & complements as a BTE
– Control of an essential facility (the only source for the complement)
• E.g., the only viable supply/distribution channels
– Control of the most efficient/cheapest complements
• Example 1: Power plants need coal. Plant A owns all local coal producers.
Plant B must buy coal from further away, paying more for transportation.
• Example 2: Coke’s exclusivity agreements with IFDs. Court rejected Pepsi’s
claim that this violated antitrust laws, but it did give Coke an advantage.
• Network effects in a MSP create a BTE that can be classified as both
economies of scale (in demand) & an access to complements issue
– E.g., if Visa cards are accepted by many merchants, the restriction on new entry
can be framed as either Visa’s greater value due to economies of scale in
demand, or as entrants’ restricted access to a complement (merchants that
accept the credit card)
78
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Entry
Other actions that impose disproportional costs
• Actions that impose lower (or no) costs on one firm (F) than a rival
firm (R) can deter R from entering a market
• Legislation / government regulation
– E.g., advertising restrictions benefit known incumbents at expense of entrants
– Powerful way to create a BTE, facilitate coordination or confront rivals
• Doesn’t violate antitrust laws
• Government pays for enforcement, imposes costs on rivals who object
• Less reputational harm (has government’s seal of approval)
– Even when government does adopt your preferred regulatory position, its
investigation may impose expenses disproportionately on your rivals
• Litigation
– Litigation often imposes costs disproportionately on parties
• One side has greater discovery & trial costs
• One side has more potential for PR harm from discovery & trial
• One side suffers greater harm from delay caused by litigation
– Threat of litigation can serve as a BTE; actual litigation can be a form of confrontation
79
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Entry
Other actions that impose disproportional costs
• Regulation (and legal issues more generally) are a common barrier to
entry because there is an inherent imbalance in lobbying for
particular regulation: incumbents know exactly what regulation
would be advantageous for them, and know how much is financially
at stake for them, so they can spend accordingly on lobbying
– In contrast, many potential entrants do not know what markets they will enter
and care to lobby on, and may consider several markets but only enter one of
them. Also, there is uncertainty what their interests are (e.g., will they be a
small player in the market or a big one?) and how much is at stake. This
reduces their incentive and effectiveness in lobbying.
– As a result, law is likely to often favor incumbents
80
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The strategic environment (competition)
Overview of Chapter 2
a)
b)
c)
d)
Economics of competition
Substitution
Entry
Rivalry
– Propensity for differentiation
– Propensity for coordination
– Propensity for confrontation
e) Supply chain
81
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Rivalry
Rivalry as a prisoner’s dilemma
• Two people are arrested. Prosecutor has evidence to convict both for
illegally possessing guns (3 yr. sentence). Prosecutor also suspects
both participated in a robbery (10 yr. sentence), but doesn’t have
enough evidence to convict unless at least one confesses.
– Prosecutor offers each prisoner to confess
• If their confession is necessary for conviction (because the other didn’t confess), they will be
set free (and the other prisoner will serve the maximum 10 year sentence)
• If the confession is not necessary (because both confess), they will both be charged with
robbery, but prosecutor will ask for a mitigated sentence (6 years) due to the confession
• If neither confesses, prosecutor will convict both for illegal gun possession (3 years)
– The prisoners have no way to communicate. What will they decide?
Prisoner A
Years in prison
Prisoner B
82
Confess
Don’t
Confess
6,6
10,0
Don’t
0,10
3,3
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Rivalry
Rivalry as a prisoner’s dilemma
• Same problem for competing firms
$M profit
Price low
Price high
– If firm A charges a high price & firm B charges a low price, Price low
1,1
0,5
customers will buy at firm B (firm A=no profit, firm B=$5M profit)
Price high
5,0
3,3
– If both firms price low, they both make low profits ($1M)
– If both firms price high, they each earn high profits but split the market between them ($3M)
– If firms have no way to communicate, they will both price low
– Lowering prices is a form of confrontation (strategic action that requires harming rivals)
• Rivalry is the degree to which rivals are likely to engage in confrontation
• Assessed by comparing rivals’ propensity for confrontation with their
propensity for pursing other strategic actions
– Differentiation: making your product less substitutable with rivals’ products
(through branding, quality variations)
– Coordination: acting jointly with rivals to maximize joint benefit
83
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Rivalry
Propensity for confrontation
• Propensity for confrontation is best measured firm by firm, by looking
for mavericks: firms that are unhappy with the status quo & are able
to change it
– Firms with an advantage in confronting rivals
– Firms who are within reach of a significant competitive advantage
• Common characteristics of mavericks
– Firm with low barriers to expansion (cheap & quick to expand production;
sometimes called “scalable business”)
• Barriers to expansion discussed in next slide
– Firm that can impose BTEs on rivals (deny rivals economies of scale/scope,
deny rivals access to complements, orchestrate regulation that excludes rivals)
• E.g., firm with deeper pockets (when access to financial markets is limited)
– Firm with much lower cost structure (can win price war)
• Same for firm with much greater network effects (can win standards war)
– Firm under (but in reach of) MES, when reaching MES give significant advantage
84
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Propensity for confrontation
Barriers to expansion
• Ratio of fixed costs to variable costs
– Easier to expand when ratio is high (i.e., most costs are FC), because expanded
production lowers ATC
– Example (differences in technology): easier to expand production of internetdownloaded music than CD-based music; easier to expand satellite TV service
than cable TV service
– Example (differences in capacity): easier to expand for firm with excess capacity
(higher FC/VC ratio) than for rivals who operate at full capacity
• Product homogeneity
– Easier to expand in a homogeneous market than in a heterogeneous one (in
latter, a marketing problem: some customers prefer rivals’ product)
– E.g., easier to expand in selling salt (homogenous) than music (heterogeneous)
• Access to distribution channels
– Lack of distribution channels limits ability to expand
85
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Propensity for confrontation
Potential competition
•
When analyzing propensity for confrontation, consider not only
existing rivals, but also potential competitors: firms making (or
expected to make) products that are likely to be part of the market
due to expected substitution changes or expected erosion of BTEs
into the market
Expected substitution changes can result from:
•
–
–
–
–
86
Changes in customer preferences
Entry/exit of products
Rebranding/repositioning of products
New technologies
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Rivalry
Incentive: propensity for differentiation
• Differentiation: reduces substitution with rivals by exploiting an
advantage over rivals in a basis of competition
• Market’s propensity for differentiation depends on:
– Bases of competition (other than price) firms can use to differentiate
– Trade-offs between bases of competition (e.g., prestige will be negatively
affected if price is lowered)
– Capacity constraints (tight constraints = less benefit from appealing to entire market)
• Differentiation is a double-edged sword
– Reduces need for coordination (confrontation is less likely)
• Firms can increase prices >MC, since their products are imperfect substitutes
– But increases cost of coordination (harder to fix prices)
• More difficult to detect deviations in quality/price
87
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Rivalry
Incentive: propensity for coordination
What does a cartel do?
• Martin, This spud’s not for you, WSJ
– United Potato Growers of America (UPGA) is a co-op that acts as a cartel of
potato growers (legal under an exemption to US antitrust rules)
• Julia Cissel, CEO of UPGA: “We’re helping people get the message of,
‘Stop overproducing’”
• What does she mean by “overproducing” - how much is the “correct”
amount to produce?
88
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Propensity for coordination
What does a cartel do?
Price
11
Demand
Curve
(P=11-Q)
8
5
Supply
Curve
3
6
11
“Overproduction”
89
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Propensity for coordination
What does a cartel do?
• “UPGA … is trying to preserve the North American potato farm”
• The trend
– Under 10K farms today; 30 years ago: 50K
• Causes
– “That’s partly because… big growers are gobbling up small ones…”
• Why are small growers being gobbled up?
– “Potatoes remain the most popular individual accompaniment to a main
dish, but people are cooking fewer at home.”
• Assume total amount of potatoes consumed remains same, but more are
consumed in fast food chains, fewer at home. Effect on the small farm?
• Note impact of distribution channels on MES
• “In years past, potato farmers were all too willing to take a loss on
sales if it meant increasing their market share. The result was that
prices became so low, the industry was unprofitable.”
– Why are farmers willing to sell at a loss?
90
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Propensity for coordination
What does a cartel do?
• How is UPGA responding to this trend?
– Cartels are a form of coordination that allows firms to raise their prices, but it
doesn’t necessarily improve production efficiency or add value
– If the problem was due to MES & production costs, how does a cartel preserve
the small potato farm?
• How is UPGA responding to this trend? (UPGA’s plan)
– “The Idaho co-op hired Jerry Wright… to handle business decisions. He pushed
the group to go national. Although Idaho produces around 30% of U.S.
potatoes, Mr. Wright believed the co-op couldn’t influence prices without
members from other big potato states.”
– How does UPGA plan to influence prices?
– Why won’t that work if they only have a 30% market share?
91
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Propensity for coordination
What does a cartel do?
• How is UPGA responding to this trend? (Process)
– Determine optimal size of the cartel (e.g., > Idaho)
• Why not go for 100% market share?
– Determine optimal (monopoly) price & quantity
– Divide quantity into member production quotas
– Monitor compliance
• UPGA uses satellite photography & GPS
– Punish violators
• Fines up to $100/acre
92
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Propensity for coordination
What does a cartel do?
• Cartels require enforcement (detection & punishment) mechanisms
because the prisoner’s dilemma still exists in the background
– “Some skeptical nonmembers [of UPGA] think the co-op is merely a way to help
large Idaho farmers who typically have overproduced… Tim Hobbs of the Maine
Potato Board[:] ‘If the problem was caused in the West, the West ought to solve
the problem.”
– For Maine potato growers, what’s the best scenario?
–
–
–
–
93
P
Not join UPGA, but UPGA succeeds
Join UPGA, UPGA succeeds
Not join UPGA, UPGA fails
Join UPGA, but UPGA fails
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Q
Propensity for coordination
What does a cartel do?
• Why is it so difficult?
– “[F]armers of fresh vegetables have tended to avoid co-ops due to market
volatility, varying regional tastes and quality-control concerns stemming from
climate differences. Potato farmers have proven especially resistant to joining
national groups, partly because different growers serve different customers.”
• (Processed) food companies: fixed production levels & prices
• Grocery stores/open market sales: prices fluctuate
• How does each of these make coordination harder?
– Cartel’s market share
– Market volatility (stability of market demand)
– Differentiation
• Differentiated goods (because of varying regional tastes & climate differences)
• Differentiated customers (customers with different bases of competition)
– Entry (if cartel succeeds & prices are high, new firms will try to enter)
94
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Propensity for coordination
Analyzing propensity to coordinate
• Before Stigler (1964), coordination was seen to be determined by
market concentration
– E.g., coordination is more likely with 3 firms that each have 33% market share
than with 100 firms 1% each
• Structure-Conduct-Performance (S-C-P) school of industry analysis
– Industry structure (mainly market concentration), affects – Individual firms’ conduct (price close to monopoly price or close to MC), which
affects –
– Firms’ performance (high or low profitability)
95
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Analyzing propensity to coordinate
Measuring market shares
Why does market share indicate possession of MP?
• Scenario 1: Acme has a 90% market share
– Acme produces 90 widgets in a market that demands 100 widgets
– Two more firms produce 5 widgets each
• Acme tries to act like a monopolist
– Acme reduces its production by 20 widgets, to 70
– Total market output is 80 while demand is 100, so prices go up
– If nothing changes, Acme captures 87.5% (70/80) of monopoly profits
• Rivals’ try to fill void
– Rivals try to raise their output by 10 widgets each (200% increase)
– Need to triple their factories, work force, purchases, etc.
– Would cost a lot & take time
96
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Analyzing propensity to coordinate
Measuring market shares
• Scenario 2: Acme has a 50% market share
– Acme produced only 50 widgets in the same market
– 5 other firms producing 10 widgets each
• Acme tries to act like a monopolist
– Reduces its output by 20, to 30 widgets
– If nothing changes, Acme captures 37.5% (30/80) of monopoly profits
• So Acme likely to make a lower cut in production (less MP)
• Rivals try to fill void
– Each rival needs to produce 4 more widgets (40% increase)
– Quicker & cheaper to do than a 200% increase
97
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Analyzing propensity to coordinate
Measuring market shares
• Criteria that reduce reliability of market shares as indicators of MP
–
–
–
–
Low barriers to expansion
Low BTEs
Significant buyer/supplier power
Highly fluctuating market shares
• Units: market share of what?
– Detailed discussion in: Gregory J. Werden, Assigning Market Shares, 70
Antitrust L.J. 67 (2002)
– Normally, market share is measured by $ revenue, but sometimes another
figure needs to be used
98
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Analyzing propensity to coordinate
Measuring market shares
• Units: when revenue info is difficult to get
– Find a proxy that is correlated to revenues or that reflect the ability to create a
price-raising shortage in the market
– Examples students used in past reports
• Capacity of airport shuttles
• Amount of X-ray liquids purchased by chiropractors
• Units: when product is free
– E.g., mobile phone operating systems: what units would you measure for MS?
– E.g., search engines: what units would you measure for MS?
• Units: when products in market vary widely in price
– E.g., food wrapping materials market includes aluminum foil & plastic wrap
• Aluminum foil costs $2.84 for 75 ft²; plastic wrap costs $1.13 for 100 ft² (85¢ for 75 ft²)
–
–
–
–
99
Company A sells 75M ft² of plastic wrap (revenue: $850,000)
Company B sells 75M ft² of aluminum foil (revenue: $2.84M)
Market shares by revenue: A – 23%; B – 77%
Does this reflect their relative MP? What would you use instead?
© Amitai Aviram. All rights reserved.
Analyzing propensity to coordinate
Measuring concentration
•
Concentration combines two issues
1.
How much market share is needed to restrict output?
•
2.
Size of coalition: how many firms must coordinate to have this market share?
•
•
–
Example: jarred baby food market
•
–
Market share (%)
2-firm concentration ratio (C2) = 65+17.4 = 82.4%
Gerber
65
3-firm concentration ratio (C3) = 65+17.4 + 15.4 = 97.8%
Heinz
17.4
Beech-Nut
15.4
Four-firm ratio (C4) is commonly used
Problem with CX
•
•
•
•
100
Often assumption is coordination of more than 4 firms is difficult to sustain
Older method: CX
•
•
Often, assumption is that you need a market share of at least 60-80%
{25%, 25%, 25%, 25%}
{49%, 49%, 1%, 1%}
What is the C4 in each market?
Is coordination easier in one of these markets than the other?
© Amitai Aviram. All rights reserved.
Analyzing propensity to coordinate
Measuring concentration
•
Newer method: Herfindahl-Hirschman Index (HHI)
–
Instead of simple adding market shares, square the market shares and then
add them
{25%, 25%, 25%, 25%}: 25² + 25² + 25² + 25² = 4 x 625 = 2,500
{49%, 49%, 1%, 1%}: 49² + 49² + 1² + 1² = 2401 + 2401 + 1 + 1 = 4,804
Why is this better than CX?
Share
S2
–
–
–
•
Example: jarred baby food
–
2.2% not accounted for in the data we have
•
•
•
–
–
101
Gerber
65
4225
Heinz
17.4
302.76
15.4
237.16
2.2
4.84
100%
4769.76
We assume it was produced by a single firm Beech-Nut
Will it cause HHI to overstate or understate
Other
concentration?
Total
Will it make a big difference?
The higher the HHI, the easier it is for firms to coordinate
HHI is most meaningful when examined in same market over time
© Amitai Aviram. All rights reserved.
Analyzing propensity to coordinate
Mergers & concentration
•
•
A merger or joint venture of rivals increases concentration
To assess the effect on concentration (and therefore on market’s
propensity to coordinate after the merger), we should consider:
–
–
•
Example: Jarred baby food
–
–
–
•
Heinz & Beech-Nut merge
Post-merger HHI: 5305.68
Delta (∆): 535.92 (5,305.68-4,769.76)
Quick way to find ∆ in a 2-firm merger
–
–
102
Pre-merger
Share
S2
Gerber
65
4225
Heinz
17.4
302.76
Beech-Nut
15.4
237.16
Other
2.2
4.84
HHI after the merger
Change in HHI due to the merger? (Delta (∆))
2 x A’s share x B’s share
2 x 17.4 x 15.4 = 535.92
© Amitai Aviram. All rights reserved.
Total
100%
4769.76
Post-merger
Share
S2
Gerber
65
4225
H + BN
32.8
1075.84
Other
2.2
4.84
Total
100%
5305.68
Propensity for coordination
Analyzing propensity to coordinate
• But concentration isn’t everything
– Industries with similar concentration exhibit different levels of coordination
• Stigler, A theory of oligopoly (1964) points out that colluding, like
other economic activities, depends on cost-benefit analysis
• Benefits to firms from coordination depend on:
– Self-elasticity of demand (more elastic = less gain from coordination, because
customers reduce demand more when price rises)
– BTE (low BTE = less gain from coordination; entrants will undercut prices)
• Costs
– Agreeing on terms (and renegotiating them)
• More difficult when member firms have different incentives
• More difficult when market widely fluctuates (renegotiation)
– Detecting cheating
• If they can’t directly observe rivals’ prices or outputs, firms deduce them from deviations in
their own expected sales, but “noise” (randomness in costs & demand) makes this difficult
– Punishing deviation (potential for successful confrontation)
• Rivals punish deviation by refusing to coordinate with a “cheater” in the future
• Better if cartel can deny the “cheater” some other benefits
103
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Propensity for coordination
Analyzing propensity to coordinate
• Stigler’s effect on analysis: shifted focus from market concentration
to coordination-facilitating conditions
– Reducing cost/increasing probability of detection
• Joint sales operations
• Information sharing & “match our rivals’ prices” promises
• Standardizing products to make cheating more transparent
– Reducing cost/increasing severity of punishment
• Joint operations (e.g., joint purchasing/sales)
• Signaling of “non-aggressive” price cuts
– Increasing benefits of cartel
• High BTE
• Low elasticity of demand
104
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Propensity for coordination
Analyzing propensity to coordinate
• Dick, When are cartels stable contracts? (1996), examined WebbPomerene Act cartels. Findings:
• Literature overstates cartel longevity, likelihood of reformation &
propensity to learn from experience
– Likelihood of reformation depends on anticipation of future government assistance
– Firms that rely on private enforcement of cartels rarely make more than a
single attempt to collude
– Many cartels created to cut costs (reach MES), not raise prices
• Variation in longevity explained by differences in the private costs &
benefits of the cartels (confirming Stigler’s views)
– Main factors: stability of market demand, product standardization, customer
size, cartel’s market share
– Cartels become less stable as they age & as they make repeated attempts to collude
– Common sales agencies increase cartel longevity; emphasizing price-fixing
destabilizes cartels
105
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Propensity for coordination
Is coordination good or bad for society?
Good
• Coordination can improve production efficiency & add value
– E.g., adopting an industry-wide standard; sharing fixed costs that aren’t fully
utilized by individual firms (e.g., R&D, distribution facilities)
• Coordination can reduce volatility in price/production
– But it is difficult to coordinate in markets with volatile demand
– So, refining this point: coordination can reduce market cyclicity caused by
volatile supply, but tends to collapse if cyclicity is caused by volatile demand
106
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Propensity for coordination
Is coordination good or bad for society?
Bad (economic reasons)
• Coordination increases firms’ market power
– Firms may try to restrict output & raise prices
– Even if they don’t explicitly attempt this, coordination can have
competition-reducing effects (reduced rivalry, increased BTE)
– Social impact of increased MP
• Dead weight loss: loss of value to potential customers who buy
product @ competitive price, but don’t buy @ monopolistic price
– Loss to customers & no gain to firm, so net loss to society
– Higher demand elasticity → higher DWL
• Wealth distribution: customers who do buy at higher price lose the portion
of the value they would have received if prices were lower
– Gain to firm equals loss to customers – is society worse off?
• Reduction in innovation
• Reduction in choice
107
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Propensity for coordination
Is coordination good or bad for society?
Bad (political reasons)
• Coordination increases firms’ political power
– But will government want to bust firm’s power? Government has dual,
competing needs from firms:
• Wants firms not to be powerful enough to ignore/thwart government
• But wants firms to be powerful enough to be co-opted to serve the
government’s goals; small, uncoordinated firms in competitive
markets can’t:
– Change industry policy
– Invest money in a social cause in lieu of government spending
– Contribute to politicians’ campaigns
– So, government is likely to want firms to have enough political & market
power to be useful to government, but not so much that they pose a
threat to government’s authority
108
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The strategic environment (competition)
Overview of Chapter 2
a)
b)
c)
d)
e)
Economics of competition
Substitution
Entry
Rivalry
Supply chain
–
–
–
–
109
Buyer/supplier market power
Price discrimination
Asset specificity
Multi-sided platforms
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Supply chain
What is a supply chain?
• Supply chain: Series of markets that together transform raw
materials into finished products delivered to consumers
• Upstream markets (in relation to a particular link of the supply
chain): markets that create raw materials for the particular link
• Downstream markets: markets that use the product of particular link
Downstream
Upstream
Producing
Raw materials
Distributing
Raw materials
Transforming
RM to goods
Distributing
goods
Consumer
Drilling
for oil
Shipping oil to
refineries
Refining oil
into gasoline
Gas
station
Car
Owner
110
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Supply chain
Buyer & supplier MP
•
Supply chains are important to the competition analysis because the
value pool (the source of firms’ profits) of the entire supply chain is
a single pool that is divided between the links (markets) of the
supply chain
Value pool (value to consumer – total supply chain costs) is divided according
to relative competitiveness of markets
•
–
–
–
111
Market’s competitiveness depends on substitution, entry, rivalry
The “unique” activity in the supply chain (very low competition) gets the
largest portion of the profits
The “commodity” activity (very high competition) gets almost no profits
© Amitai Aviram. All rights reserved.
Supply chain
Buyer & supplier MP
• Example: To simplify, suppose that only use for crude oil is gas. Car
owners would pay up to $3/gallon for gas; cost of drilling,
transporting & refining: $2/gallon. Total gas sales: 100B gallons
– How will the value pool ($100B) be appropriated?
– Suppose oil extraction is monopolized, while competition in transporting,
refining, retailing & purchasing gas is very fierce
– Result: The extraction market will appropriate most of the value from the VP at
the expense of the transporting, refining & retailing markets
Drilling for oil
(extraction)
112
Transporting
oil to refineries
Refining oil
into gasoline
© Amitai Aviram. All rights reserved.
Gas station
(retailing)
Car
owner
Supply chain
Buyer & supplier MP
• To assess buyer & supplier MP
– Conduct a brief evaluation of substitution, entry & rivalry for each link of the
supply chain
– If this “quick look” suggests significant MP, conduct a more thorough evaluation
of that link & look for evidence of exercising MP
• Buyer/supplier power when your firm also has MP (stacked monopolies)
–
–
–
113
When both a firm & its buyer or supplier have MP, each firm reduces output to
maximize price under the assumption that the other firm will do the same
• E.g., monopolist oil company & monopolist refinery: refinery will buy assume
oil costs a monopoly price (pushing gas prices up), then it will further raise
gas price to get monopoly profits on gas
Result is bad for both firms: higher price & less output than if a single monopoly
operated both drilling & refining activities
Coordination of the two firms would increase output & decrease price (from
stacked monopoly price to single monopoly price)
© Amitai Aviram. All rights reserved.
Supply chain
Buyer & supplier MP: Price sensitivity
• Competition analysis (substitution, entry & rivalry) indicates a
buyer’s/supplier’s ability to get a better price (by acting like a monopolist)
– However, there are costs involved in acting like a monopolist, so the use of MP
also depends on its incentive (i.e., how much does it care to get a better price?)
• This is measured by a buyer’s/supplier’s price sensitivity
– In the case of your customers (buyer power), this is the self-elasticity of
demand in your market (less price-sensitive = less MP concern)
• Price sensitivity is often a matter of how significant the price of your
component is to the other party’s profitability
– E.g., if you create a $5 chip in a $500 tablet, doubling your price (100%
increase) only adds 1% to the tablet’s cost – might not be a priority for the
tablet manufacturer to lower your price
• Framing is sometimes used to reduce price sensitivity
– E.g., selling a product as an add-on to a much more expensive product
114
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Supply chain
Price discrimination
• Price discrimination is a way to extract more of the VP (at customers’
expense) than a firm that sells @ monopoly price
– So, supply chain analysis needs to
consider your ability to price discriminate
(reduces buyer power) & suppliers’
ability to price discriminate against you
(increases supplier power)
Price
11
• Recall our analysis of a monopoly
– Why doesn’t the monopolist sell to
customers in the red triangle?
(those willing to pay >$5 but less than $8)
– Price discrimination is a way to sell to
those customers without losing
revenue from customers who are
willing to pay >$8
115
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8
5
Cons.
Surplus
Producer
Surplus
Total
Cost
3
6
11 Quantity
Supply chain
Price discrimination
• Firm divides customers into 2 groups
– Cheapskates: those who value widgets
more than $6 but less than $8
– Suckers: those who value its widgets
at or above $8
•
•
•
•
•
Sells 3 units @$8 to the suckers
Sells 2 units @$6 to the cheapskates
TR = $36 ($24 + $12)
Cost = $28 ($5 x 5 units +$3 overhead)
Profit = $8
Price
11
8
6
5
– Compared to $6 with a single price
• Problems with this plan?
3
116
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5 6
11 Quantity
Supply chain
Price discrimination - conditions
• Prefect price discrimination requires:
– Ability to costlessly determine the value of the product to each
customer
– Inability of customers to acquire the product elsewhere
• No competition
• Inability of customers to resell
– Positioning (reputation, brand)
– Legally permissible
117
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Supply chain
Price discrimination: how?
• Discriminating by customer efforts
– Coupons
• Discriminating by time
– Hardcover books before paperbacks
– First-run / second-run movies, delayed release to DVD
• Discriminating by extra features
– “Limited edition” DVDs or computer games
• Discriminating by measuring use
– Bundling (variable proportions)
• Discriminating by value averaging
– Bundling (fixed/no proportions)
118
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Supply chain
Price discrimination: how?
Bundling (variable proportion products)
• Example: Printer & toner: heavy users use more toner than
light users
– Who is likely to value a printer more?
– Costs
• Printer $100; Toner $1; Toner can print 1,000 pages
– Value to customers: 1¢ of per printed page
• Customer A will print 20,000 pages (20 toners). Value: $200
• Customer B will print 30,000 pages (30 toners). Value: $300
119
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Supply chain
Price discrimination: how?
Bundling (variable proportion products)
• Price printer @ cost & toner @ highest possible price
– A will pay up to $200: $100 for printer & $100 for toner ($5 ea.)
– B will pay up to $300: $100 for printer & $200 for toner ($6.67 ea.)
• Firm’s options
– Toner @ $5 (sell 50): Profit $200 (50x$5)-(50x$1)
– Toner @ $6.67 (sell 30): Profit $170 (30x$6.67)-(30x$1)
• Why do firms typically bundle toner rather than paper?
120
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Supply chain
Price discrimination: how?
Bundling (variable proportion products)
• Another example: Popcorn in movies
121
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Supply chain
Price discrimination: how?
Bundling (fixed/no proportion products)
• Firm sells two movies: When Harry Met Sally (Romantic
comedy) & Spaceballs (Sci-Fi comedy)
– Each DVD costs $5 to produce
• Value to Customers
– Romantics value WHMS @$10 & Spaceballs @$6
– Sci-Fi fans value Spaceballs @$10, and WHMS @$6
– Assume market includes one romantic & one sci-fi fan
122
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Supply chain
Price discrimination: how?
Bundling (fixed/no proportion products)
• Firm sells the movies separately
– Prices each movie @$6
• Firm sells 4 movies (2/customer); profit: $4 [(4x$6)-(4x$5)]
– Prices each movie @$10
• Firm sells 2 movies (1/customer); profit: $10 [(2x$10)-(2x$5)]
• Firm bundles, sells combo @$16
– Firm sells 2 bundles; profit: $12 [(2x$16)-(2x$10)]
123
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Supply chain
Asset specificity
When is opportunism most likely?
• Hypo: a newspaper hires a lawyer to review a lease. The
market for lawyers is competitive, with a dozen lawyers
willing to do the job for $200
• After signing a contract with lawyer A, he holds out &
demands $300 or he won’t do the job
– Is the newspaper likely to concede to A’s demand?
• What if the market is not competitive at all - A is
the only lawyer available who can do this job
(i.e., no substitution, entry & rivalry)?
124
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Supply chain
Asset specificity
• The newspaper also determines that it
doesn’t have a competitive advantage in
printing, so it wants to outsource its printing
functions
• To meet tight deadlines, the printer’s
machines must be connected to the editorial
board’s computers
– This costs $10M
– The $10M are lost if the newspaper stops
working with that specific printer
• The printing market is competitive, with a
dozen printers willing to work for $200/day
125
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Supply chain
Asset specificity
• The newspaper signs a contract with printer
C, at a price of $200/day
• After the newspaper spends $10M to connect
its computers with Printer C’s system, Printer
C refuses to honor the agreement unless the
price is raised to $300/day.
– Buyer/supplier power reflects the risk of
opportunism by buyers or suppliers
• Is the newspaper likely to concede to C’s
demand?
– Note that the printing market is competitive – is it
the same as the original law firm situation?
126
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Supply chain
Asset specificity
• Compare the following scenarios:
– A Burger King franchisor hires a new burger-flipper. After a
year on the job, the employee demands a big raise, or he’ll quit.
– Goldman Sachs hires a stock trader. After a year on the job, the
employee demands a big raise, or she’ll quit.
– Warner Brothers hire Daniel Radcliffe to play Harry Potter in the first of
seven planned movies. After the debut of the first move, Daniel
demands a big raise, or he won’t play in the future movies.
• In which of these is the employer most likely to give a raise?
127
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Supply chain
Asset specificity
• Williamson noted that the risk of opportunism
depended on asset specificity (the lost value if an
asset is deployed in another business)
– Asset specificity increases as more relationship-specific
investment is needed to unlock its value
• Party that has less relationship-specific investment
may act opportunistically
• What’s the asset specificity (the relationshipspecific investment) in each case:
– Burger King & the burger-flipper
– Goldman Sachs & the stock trader
– Warner Brothers & Daniel Radcliffe
128
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Oliver
Williamson
Supply chain
Asset specificity - Types
1. Site specificity
–
–
E.g., transporting coal is expensive, so coal power plant is best located near a
coal mine
Result: plant is vulnerable to coal mine raising prices
2. Physical asset specificity
–
–
Cars can be made to run on gas or diesel, but it is expensive to switch from one
to the other
Result: drivers are vulnerable to gas/diesel prices going up
3. Dedicated assets
–
–
129
Assets made specifically for particular user, that would have otherwise not
been made (e.g., custom-tailored clothes)
Result: once made, customer can renegotiate under threat of reneging
© Amitai Aviram. All rights reserved.
Supply chain
Asset specificity - Types
4. Human asset specificity
–
Development in human capital (learning, team building) that is lost if individual
shifts to another job
5. Intangible assets
–
E.g., reputation, brand name
6. Temporal specificity
–
–
–
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Timing of product is crucial, so delay would lose much of its value
E.g., if newspaper/sports broadcast comes out a day late, it is worthless
Result: threat of a delay can be used to renegotiate better deal
© Amitai Aviram. All rights reserved.
Supply chain
Multi-sided platforms
• Multi-sided platforms are products that allow direct interaction
between 2 or more types of customers
– E.g., credit cards (shoppers <-> merchants); newspapers (readers <-> advertisers)
• Rivalry in MSPs
– Confrontation between MSP participants is more beneficial to stronger parties
(excluding smaller participants from the MSP can eliminate or greatly weaken them)
– Coordination between MSP participants is harder to detect: easy to mask
coordination as necessary communications
– Both confrontation & coordination between MSPs are more likely while the
MSPs operate below MES
• A race to consolidate & become the largest MSP
– Confrontation between MSPs more likely & coordination less likely when one
MSP reached MES and the other has not (small MSPs want to interconnect with
larger ones; large MSPs try to resist this)
• Large MSPs want to protect their market dominance
• Large MSPs want to recoup cost of developing their network
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© Amitai Aviram. All rights reserved.