Download Lecture Notes 6 - Metropolitan State University

ECON 696: Managerial Economics and Strategy
Lecture Notes 6: Competitors and Competition
Behaving strategically means knowing who your competitors are and how they will
respond to changes in your behavior. This chapter discusses different types of markets,
how firms in them behave and the effects of this behavior on profitability.
The chapter starts with a discussion about the tricky processes of defining a market and
identifying competitors. It also introduces the concept of market concentration.
The chapter then discusses the four standard market structures: perfect competition,
monopoly, monopolistic competition and oligopoly. Oligopoly includes two types of
competition: Cournot or quantity competition and Bertrand or price competition.
Finally, the relationship between market structure and profitability is examined.
Identifying Competitors and Defining Markets
1. Identifying competitors
The text describes pretty clearly what a competitor is, or how you determine whether a
particular firm is a competitor. There are two important definitions.
The first definition is mathematical and is derived from the formula for elasticity. The
usual form for an elasticity calculation is the percentage change in quantity divided by the
percentage change in price, which may be written in a variety of ways:
Q2  Q1
Q
Q  Q1
%Q
Q


 2
P
P2  P1
%P
P
P2  P1
In determining whether or not goods are substitutes for each other, you might calculate
the percentage change in the quantity of one is divided by the percentage change in the
price of the other. This version of elasticity is called the cross price elasticity.
If two goods, x and y, are being considered, the cross price elasticity of these may be
described either as
xy 
or as
%Q x
%Py
yx 
%Qy
%Px
If two goods are substitutes, an increase in the price of one should be accompanied by an
increase in the quantity of the other, holding other things constant. As a result, if two
goods are substitutes, their cross price elasticity will be positive.
The second definition is descriptive and focuses on the characteristics of the product
being sold. The book discusses some specifics, but in practical terms, any option that a
reasonable consumer is likely to consider when making a purchase is a substitute. This
will typically include goods which:
 serve the same function
 have similar characteristics (including price)
 are available in the same general location.
The second definition of substitutes is more intuitive and perhaps more useful, but the
first is more precise. You might agree that margarine and butter are substitutes, but what
about margarine and cooking oil or vegetable shortening? Both may be used for frying,
but vegetable shortening is generally not used on toast. If data could be obtained on the
prices and quantities sold of margarine and vegetable shortening, a definite answer could
be offered as to whether or not they are substitutes by calculating the cross price
elasticity. If they are substitutes, the larger the calculated elasticity, the more likely
consumers are to substitute between the two goods.
This is important because substitutes compete with each other for customers. If you can
identify which goods your consumers are likely to substitute for yours, you will know
which products' prices and marketing programs you need to monitor.
2. Defining markets
A market is defined by the consumers and suppliers who buy and sell goods which are
close substitutes for each other.
As it is with substitutes, markets include goods which serve as practical substitutes for
each other.
Market structure is described by the number of consumers and suppliers, their relative
sizes and the degree to which the products sold are substitutes. In this chapter, we will
focus on suppliers, although there can be important issues relating to markets with small
numbers of very large consumers.
Two important aspects of market structure are concentration and product differentiation.
The degree to which a small number of firms controls a market is the level of
concentration in that market. In a concentrated market, there are either a small number
of firms or a small number of very large firms and, perhaps, many small ones. The
automobile market in the U.S. is very concentrated because there are a small number of
very large firms manufacturing and selling cars. The beer market in the U.S. is very
concentrated despite the existence of many small breweries because it is dominated by a
small number of extremely large companies.
The degree to which consumers are willing to substitute between products in a market is
the level of differentiation in the market. If every seller is offering the same exact
product at the same location and time, there is no product differentiation. If products
differ in their characteristics, location or the time at which they are offered, this may
increase the level of product differentiation.
Market structure is important not only because of its effects on how firms act in response
to each other, but also because of its effects on an individual firm's behavior. If there are
many firms in a market selling very similar products, any one firm will be unable to raise
its prices very much because its customers will simply seek out another seller.
Put another way, when there are many other sellers in a market, demand for any one
seller's product will be very elastic. If price increases, even by a small percentage, the
resulting decrease in the quantity sold can be huge. Similarly, if a seller lowers prices,
the resulting increase in quantity sold can be huge.
As an example, consider the market for gasoline. While there are no good substitutes for
gasoline, the manager of any one gas station knows that the gas sold at nearby stations is
a very good substitutes for the gasoline she is selling and she can lose most of her
business by raising the price slightly or can have lines at the pumps by lowering it
slightly.
If a market has very few sellers, or if the products are very distinct, one firm may be able
to raise its prices quite a bit without losing too many customers. At some point,
customers may seek out poor substitutes or simply stop buying the good, but they will
tolerate some level of price increases.
3. Measures of market concentration
The most quantifiable aspect of market structure is the level of concentration of a market.
There are two commonly used measures of this.
The first is a concentration ratio, a measure based on the percentage of sales made by the
largest firms in the industry. A four firm concentration ratio is the percentage of the
market's sales made by the four largest firms, an eight firm concentration ratio is the
percentage of the market's sales made by the eight largest firms. These are useful
because they are relatively easy to calculate and understand and the largest firms in a
market probably have the greatest impact on how the market performs, but they are
somewhat lacking both because they ignore the smaller firms in the market and they fail
to recognize the importance of changes in market share between the largest firms.
For example, if the four largest firms in a market have market shares of 15%, 10%, 8%
and 7%, the four firm concentration ratio would be 0.40. If the largest firm attracted
customers away from the other large firms so that the market shares changed to 20%, 7%,
7% and 6%, the four firm concentration ratio would still be 0.40. This is in spite of the
fact that the largest firm has gone from being 50% larger than its nearest competitor to
being nearly three times its size.
A more precise measure of market concentration is given by the Herfindahl index (HI),
also known as the Hirshman-Herfindahl index (HHI). This is equal to the sum of the
squared market shares of each firm in the market.
For example, imagine a market with five firms which control 35%, 30%, 20%, 10% and
5% of sales. The calculated HI for this market would be
HI  0.352  0.302  0.202  0.102  0.052  0.265
For reasons too complicated to explain here, this is sometimes multiplied by 10,000, so
some people would say that the HI in this market is 2650.
The HI is a better indication of concentration because it considers the structure of the
entire market rather than just the largest firms. It also has the interesting characteristic
that a market with many firms but a HI of, say, 0.25, will function similarly to a market
with
1
4
0.25
equally sized firms.
When the Department of Justice is considering whether or not to allow mergers, they
look at the expected effect of the merger on the HI. If a merger will result in a large
enough increase in the HI in a market, the merger will be examined more closely.
Four Market Structures and Their Characteristics
The four standard market structures considered in economics are
 Perfect competition
 Monopoly
 Monopolistic competition
 Oligopoly
There are some things to say about each, but one very important characteristic is the
freedom with which firms may enter or leave a market. In perfect competition and
monopolistic competition, firms can easily enter or leave the market. The result is that
profits for a typical firm will be driven to zero in the long run. In monopoly and
oligopoly, barriers to entry keep new firms out and can preserve large profits over a long
period of time.
Perfect Competition
Perfect competition is an idealized market structure in which many firms produce
identical goods (identical right down to the location at which they are sold), there is
perfect information about prices and about the goods being sold and there are no barriers
to entry. This is not descriptive of many markets in the real world, but it is a benchmark.
Under these conditions, each firm will take the market price as given and, in effect, will
face a horizontal demand curve. This means that any one firm cannot raise its price, even
slightly, or it will lose all of its customers.
If profits are positive in a perfectly competitive market, these positive profits will attract
new firms to the business. The entry of new firms will increase supply and drive prices
down. Entry will continue and the price will fall until it becomes unprofitable for new
firms to enter. At this point, entry will cease and a typical firm in the market will earn
zero economic profits.
Zero economic profits differs from zero accounting profits in that when a firm is earning
zero economic profits it is just covering the cost of the business owner's time and is
earning a fair return on its capital. While it may not be doing particularly well, it is
making enough to keep it in business.
In long run equilibrium with zero profits, a typical firm can be described by the following
diagram:
Long run price is equal to minimum average cost. Basically, this means that it is
impossible for a typical firm to produce more cheaply than firms in competitive
industries.
This has an important implication for vertical integration. If a company is buying an
input in a competitive market, it is unlikely that they will be able to produce that input at
a cost below the market price.
It may be the case that some firms in a competitive market have some sort of cost
advantage which other firms cannot replicate. These firms would make positive
economic profits, but these added profits would be more properly called a rent earned by
their special advantage.
Monopoly
A monopoly is a market served by one firm facing a downward sloping demand curve
and protected by significant barriers to entry. Because a monopolist faces no real
competition, it is free to choose its own price with the understanding that higher prices
will lead to a smaller quantity sold.
Of course, whether a market is really served by only one firm depends on how the market
is defined. There may be only one grocery store on a block, but that is hardly an
important monopoly in a city with hundreds of grocery stores.
While very few markets are actually served by only one firm, there are some
characteristics of monopolies which are important in the real world.
First, for any firm protected by barriers to entry, positive economic profits can be
maintained in the long run.
Second, when a firm has some choice as to what price it charges (as most firms will)
selling additional units by lowering the price typically comes at the cost of revenues on
units which would have been sold anyway.
Third, there is no guarantee that a firm will be operating at or near minimum average
cost.
The implication for vertical integration is that if a firm is purchasing an input from a
monopolist may be able to produce that input internally at an average cost lower than the
price paid to the monopolist. The difficult consideration here, however, is that the
monopolist is protected by some barrier to entry which may also prevent internal
production.
Monopolistic Competition
Monopolistic competition describes a market in which there are many seller and free
entry, but each seller has a product which is somewhat differentiated from other firms'
products.
My favorite example of a monopolistically competitive market is the market for lunch in
a busy business district or near a university. The barriers to entry are minimal, so if
restaurants are making large profits new places will open and demand for each of the
existing firms will fall. There will be many restaurants open for lunch, with each offering
different dishes. Each restaurant knows that it can raise its price and lose some of the
more fickle customers while maintaining its core group of patrons. Alternatively, each
restaurant can lower the price or expand their menu and steal some business from other
restaurants in the area.
There are two important ideas which come out of the analysis of monopolistically
competitive markets.
The first is that in long run equilibrium profits will be driven to zero, but average cost
will not be minimized. The implication is that if an input is being purchased from a firm
which is monopolistically competitive, the supplier may not be profitable, but they may
not be minimizing costs. However, as other firms' products become closer substitutes,
the price paid may approach minimum average cost.
The second is that firms actively choose the characteristics of their product after
consideration of what other firms are currently selling and what they think people want.
The characteristics may be the spiciness of the curry offered for lunch, the size of an
automobile's engine or the alcohol content of a malt beverage. The idea is that if all
products sell for the same price, a firm will capture all the customers whose preferences
most closely approximate their product's characteristics. In the context of the straight
line model given in the book, a firm will capture those customers closer to it than to a
competitor.
In a more dynamic context, firms will make choices about the characteristics of their
products anticipating responses by other firms. This can all get very complicated, but
you should at least be aware that product characteristics are one of the ways in which
firms battle over customers.
Oligopoly
Strategy becomes most important in an oligopoly, a market characterized by a small
number of firms with significant barriers to entry. In such a situation, positive profits
may be maintained, but a firm must continuously consider how other firms will react to
changes in its behavior. This is different from monopoly, where a firm has no
competitors to consider and from both perfect and monopolistic competition, where
profits are likely to be driven to zero in the long run regardless of a firm's behavior.
The next few chapters of the book really focus on the behavior of firms in oligopolies.
Most important will be the two standard models of oligopoly behavior, the Cournot
model and the Bertrand model.
In the Cournot model, firms decide what quantity to produce and the price is determined
by the total quantity produced by all firms in the market. If one firm cuts its production,
prices will rise and other firms can increase their profits (at least in the short run) by
increasing their output. Firms collude by simultaneously lowering the quantity that they
produce and the result is high price and high profits. In general, the smaller the number
of firms in a market, the higher will be the profit per firm.
In the Bertrand model, firms decide what price they want to charge and are prepared to
meet the entire market's demand at that price. If two firms are charging the same price,
they will equally divide the market. In such a situation, however, each firm knows that it
could slightly undercut the other and capture the whole market, at least until the other has
the opportunity to respond. The curious thing about Bertrand competition is that the
entry of one firm into a monopoly (creating a duopoly, a market served by two firms) can
lead to competition which can drive price down to marginal cost, the competitive result.
It is strange that going from one firm to two firms can drive the market from the
monopoly result to the competitive result.
In both models, however, firms may realize that trying too hard to compete with other
firms in the market can be self-destructive as other firms may be expected to retaliate.
In addition, it seems reasonable that the fewer firms there are in a market, the less likely
it would be that any one firm would try to undercut its rivals and ruin a situation in which
all firms had high profits. Despite this, studies of oligopolistic industries seem to indicate
that even markets with small numbers of firms seem to be characterized by healthy
competition and modest profits.
Conclusion
Markets can be hard to define and any definition of a market must consider the degree to
which substitutes are available and whether or not competitors are geographically
relevant. A handy tool for determining whether two goods are in the same market and
are substitutes is their cross price elasticity.
Once a market is defined, one of the most important characteristics of a market is the
level of concentration, which may be characterized by a concentration ratio or by a
Herfindahl index number.
Four important market types are the perfectly competitive, monopolistic,
monopolistically competitive and oligopolistic markets. Free entry drives profits to zero
in the perfectly and monopolistically competitive markets while barriers to entry can keep
economic profits high, even over long periods of time, in monopolistic and oligopolistic
markets.
Strategy is most important in oligopolistic markets, where a small number of firms
compete with each other from one year to the next. In the Cournot model of oligopoly,
firms choose the quantity they will produce and let the market determine the resulting
price. In the Bertrand model firms choose the price they charge and stand ready to sell to
the entire market at that price.