Download Chapter 6: Market Structure Chapter 8: Competitive Strategy

Chapter 6: Market Structure
Chapter 8: Competitive Strategy
Review Assignment 1
Market structure archetypes
• Defining your Market
• Perfect competition
• Monopoly
Competitive Strategy
• Creating Value
• Capturing Value
• Porter’s Five Forces
Del Monte Fresh Pineapple
Walmart, p. 221.
Defining your market
• The boundaries of an economic market should
include all the firms & their products that
interact to determine prices
• Analyze each of your markets separately
• Can use both qualitative & quantitative
methods for identifying competitors (i.e.
substitutes)
• Geography may be important
Defining your market
Qualitative approach
• Product performance characteristics
– Red roof inn, Motel 6
• Occasions for use
– Coke and bottled water
• Geographic market
– Local; national; global
Defining your market
Quantitative criteria
• Demand elasticities
– Price elasticity
• higher => look for lots of competitors
– Cross-price elasticity
• Strongly positive => close substitutes
• Price correlations
– Airfares moving together
• SIC codes may help
–
–
–
–
U.S. Census Bureau conducts Economic Census every 5 years (92, 97,02)
Firms are categorized according to type of product or service provided
In each category: # firms, sales, payroll, employees
http://factfinder.census.gov/
• Example of SIC codes
– 311 Food mfctg
• 3112 Grain & oilseed milling
– 31121 Flour milling & malt manufacturing
» 31123 Breakfast cereal manufacturing
• Your market may not fit in neatly
Market Structure
• Defined by attributes of the market environment
– Number & concentration of the participating firms
– Characteristics of the product(s) they sell
• Affects behavior of participating firms
Concentration
– As the degree of concentration increases, it may be
possible for firms to gain pricing advantage (but not
necessarily)
– A measure of concentration is useful in describing the
nature of a market
Market structure
concentration measures
• Concentration ratios (97 Economic Census)
% of sales of the top n firms in each NAICS code
• Herfindahl-Hirschman index (HHI)
– 10,000 x The sum of squares of each firm’s
fraction of industry sales
– Monopoly HHI = 10,000
– Merger guidelines
• < 1000 unconcentrated
• 1000 < HHI < 1800 moderately concentrated
• > 1800 concentrated
Definitions of Market Structures
Product Type/
Information
# of sellers /
entry barriers
Behavior
Homogeneous/
Good info about price
and quality
Many /
Very competitive low
prices
Monopolistic
Competition
Differentiated
Many/
Relatively low
Relatively low
Can be quite competitive price, brand, quality, etc.
Oligopoly
Homogeneous or
differentiated
Few; or a few
large firms with
fringe of small
firms
/moderately high
Strategic interaction
Competition can vary
depending on situtation
Monopoly
Absence of close
substitutes
One/
Very high
Cushy position, high prices
May strategize to keep
barriers high
Perfect
Competition
low
Monopoly – “Mono” “opoly”
•
•
•
•
•
Strong barriers to entry  single seller
Product has no close substitutes
Price “maker” (“searcher”)
E.g. Prilosec by Astra-Merck in 1996
Gasoline on Toll Roads
Barriers to entry
•
•
•
•
Specific assets
Economies of scale
Excess capacity
Reputation effects
•
•
•
•
Pre-commitment contracts
Licenses and patents
Learning-curve effects
Pioneering brand
advantages
Optimal Single-price Pricing
• Pricing objective – maximize total profit
• MR = MC for optimal output
=> Optimal markup formula
P
MC
1
1

at optimal output Q*
Application: The elasticity of demand for gasoline on the New
Jersey toll road = 10.
What markup would a profit maximizing firm use???
P
1
1
 MC   MC  1.11%  MC
.9
1 1
10
Derivation of Optimal Markup Rule
From Profit Maximization:
Working with MR side:
TR / Q = MC
MR = MC
(defn of MR)
(P Q + Q P) / Q = MC (breakdown of TR)
P + Q( P / Q) = MC
(a little algebra)
Here comes elasticity:*
P - Q[(1 / )(P / Q)] = MC
P[1 - (1 / )] = MC
(Factor out P; cancel Q’s)
Optimal markup rule:
P = MC / [1 - (1 / )] (Divide by [ ] term)
___________________________________________________
*Need equation (1) for the elasticity step above:
Defn. of elasticity

 = (-1)(Q/Q) / (P/P)
Multiply by reciprocal

 = (-1)( Q/Q)(P/P)
Rearrange

 = (-1)( P /Q) ( Q /P)
Solve for (-1) ( P /Q)

P /Q = (-1)(1 / ) (P / Q)
Monopoly: Markup and Profits
P
MC
PM
AC
Markup
Average Cost
of Producing
Each Unit
A
D
B
QM
Q
MR
Perfect competition
characteristics
• Many buyers and sellers
• Low seller concentration (each firm has low market
share)
• Homogeneous product
• Low cost and accurate information about product and
price
• Price “taker”
• Free entry and exit
• E.g. commodity markets; agricultural products
Entry and pricing
perfect competition
• Above normal profit
 Attracts entry
 Increases market supply
 Reduces market price
 Reduces unit profit (P vs. ATC)
• Below normal profit
 Promotes Exit
 Decreases market supply
 Increases market price
 Over time, increases unit profit (P vs. ATC)
Perfect Competition: Long run Pricing
After entry/exit
MR = MC → firms use equimarginal thinking
P = min LRAC → so efficient production
Normal Profit = 0 economic profit
Monopoly Versus Perfect
Competition
(b) Perfect Competition
(a) Monopoly
P
P
Consumer Surplus
Consumer Surplus
MC
MC
PM
Deadweight
Social Loss
A
P1
D
Producer
Surplus
QM
D
Q
MR
Q1
Producer
Surplus
Q
Application:
• Pick a market/industry with which you are
familiar. Based on your text reading, how
would you describe its market structure and
why? How narrowly/broadly are you defining
the market (e.g. does Coke compete in all
beverages or bottled soft drinks)? How would
you characterize barriers to entry to this
market?
Strategy
• General policies intended to generate profits
– Choice of industry
– Combination of products and services
– Competitive and cooperative behaviors
• Strategies evolve as circumstances change
• Strategies must create and capture value
Creating Value for Consumers
A firm has market power if…
...it faces a downsloping demand curve.
The firm’s pricing objective is…
…to maximize shareholder value.
The demand curve reflects…
…consumer willingness and ability to buy.
Consumer surplus = consumers’ gains
from trade
Ways to create value
Del Monte Gold: A sweet example??
Market Structure and Capturing Value
• Firms in competitive markets are price takers
• Market power and superior resources can lead
to economic profit
• Going for the Gold and Pineapple Acid Test, WSJ
– What are/were the barriers to entry into the
premium pineapple market?
– What is/will be the market structure of the
premium pineapple market? Profitability?
Example: Pineapple value
• $5 reservation price
• $1.50 cost
• 1 pineapple
$3.50 value created
• willingness to pay or
reservation price
– Demand strategy
• Cost 
– Low cost strategy
• Q
– Demand strategy
Value created 
Example: Pineapple value
continued…
• $5 reservation price
• $1.50 cost
If purchased at $3
Consumer surplus = $2.00
Producer surplus = $1.50
• 1 pineapple
$3.50 value created
So firm only captures
$1.50 of $3.50 value
created…
Porter’s five forces
•
•
•
•
•
Potential rivals
Existing rivalry
Substitute products
Buyer power
Supplier power
Let’s go to the video tape
Superior factors of production
• People
– special talents or skills
• Physical assets
– prime real estate
– unique equipment
• But bidding for specialized assets may
erode profits
Producer surplus captured by superior assets
Superior factors of production
• Team production
– interdependencies among workers increase value
beyond the “sum of the parts”
– luck or foresight may endow firms with unique
team production capabilities
• Rivals may be unable to pinpoint source of
advantage and unable to capture equivalent
value
Wal-Mart, p. 221
• What is the impact of Wal-Mart.com on customerborne transaction costs?
• Do you think that Wal-Mart.com is likely to create
additional value?
• Is it likely that Wal-Mart will capture any value
created by Wal-Mart.com?
• Should Wal-Mart have pursued e-commerce more
aggressively sooner?
• What do you think the potential impact of WalMart.com will be on the company’s efforts to expand
internationally?
Looking Forward
•
Assignment 2
–
•
Due on October 14,18 or 19
Read
–
Managerial Economics
•
–
Coursepack
•
•
•
•
Chapter 7 – Pricing
The Power of Smart Pricing
The Usual Decorous Waltz…
The Myth of Market Share
Blackboard
–
Why are Hotel Minibars So Expensive?” - Glenn Ellison