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Strategic Management II
1. Market structure and competition - Chapter 5
Industry: Are the set of producers of goods or services that share similar functional
Competitors: Are the firms that sell products with similar functional characteristics ( if their products are substitutes).
Substitutes: Two products X and Y are substitutes if an increase in the price of X reduces the sales of X and increases the sales of Y. The degree of substitutability of one product for another is measured by the cross price elasticity of demand, which measures the percentage change in demand for good Y that results from a onepercent change in the price of good X. Two products tend to be close substitutes when: o They have similar performance characteristics.
o Listing of performance characteristics is a subjective but useful exercise.
o They have similar occasion for use.
o They are sold in the same geographic area (Identical products in two different geographic markets may not be substitutes due to “transportation costs”).
Anticompetitive conduct: It’s forbidden to merge when it leads to a Small (5%) but Significant and Non-transitory (more than one year) Increase in Price (SSNIP).
o The first step for applying the SSNIP criterion is to define competitors and the market.
o The second step is to anticipate the best response of competitors to the merger.
Structure and Concentration The structure of a market is determined by the number of participating firms and their respective sizes. This allows for an assessment of the likely nature of competition in a market. The market structure can be quantitatively measured with a concentration index.
Concentration is low if a market is very fragmented, with many small-size firms, and concentration is high if there are few large-size firms.
The Herfindahl Index: ∑ Thus, if: - H>0,6: Monopoly - 0,2<H<0,6: Oligopoly 1 - H<0,2: Perfect (or monopolistic) Competition Empirically there is a positive correlation between market concentration and prices, but we can rely on it (correlation vs causality). Concentration measures are not a very good measure of competition. (We need to analyze firm competitive behavior).
Typology of Industries - - Perfect competition: Many firms that are too small to individually affect each others’ decisions. Free entry and exit typically dissipate all value. Fierce price competition.
Monopolistic competition: May be fierce or light price competition, depending on product differentiation.
Monopoly: A single firm largely controls the market with little effective competition (cares only about future entry and substitutes from other industries). Light price competition, unless threatened by entry.
Oligopoly: Few firms that acknowledge strategic interaction. Analyzing interaction is often complex and game theory very useful. May be fierce or light price competition, depending on interfirm rivalry.
Conditions for Fierce Competition Price competition can be fierce when two of the following conditions are met: - There are many sellers: With many sellers, cartels and collusive agreements harder to create. (Cartels fail since some players will be tempted to cheat since small cheaters may go undetected the incentives to reduce the price are larger since firms have lower market share). Moreover, there will be diversity of pricing preferences and cost functions - There is excess capacity: When a firm is operating below full capacity it can price below average cost as price covers the variable cost. If industry has excess capacity, prices fall below average cost and some firms may choose to exit.
- Customers perceive the product to be homogenous: If there is no differentiation between products, firms compete only in price.
2 Perfect Competition The theory conceptualizes the maximum intensity of competition (no firm alone has an effect on market price). Here, P=MR=MC, and the equation holds: , where . Firms obtain zero economic profits. This model assumes: - A large number of buyers and sellers.
- A homogeneous product.
- Perfect information about prices and products.
- Free entry and exit (the production technology is available to everyone).
- No scale economies.
- Zero transaction costs.
Monopoly In a monopoly, there is only one firm controlling and supplying the whole market, with little or no risk of entry. MR won’t be equal to P (If elasticity 𝝶<∞, then it’s possible to extract monopoly rents).
Oligopoly To study imperfect competition, we consider the case in which there are few firms in the market. When there are few firms, every firm recognizes that its optimal actions depend on what the others do. That is, the actions of each firm affect the market and game theory have an important role.
How can we explain imperfect competition in oligopolistic markets? - Capacity constraints.
- Product differentiation.
- Repeated interaction.
- Asymmetric information.
- Bertrand Competition We will analyze the duopoly case: - 2 firms.
- Both firms have identical marginal cost.
- Homogeneous products.
- Compete only in price.
- Demand is decreasing in price (and continuous).
- If both firms quote the same price, the market share is split evenly.
3 This is a paradox because monopoly profits disappear with only one competitor; both firms get the perfect competition outcome with very fierce competition in price. This result doesn’t change if we increase the number of competitors. The unique ways to make positive profits are to lower average cost and to cooperate/collude.
- Cournot Competition In this game, firms decide their quantity (understand capacity), and then let prices be determined by demand given the total quantity supplied in the market. It’s used when firms cannot change easily capacity and output (if they set production in advance), such as mining, electricity, gas… For the case of n=2 firms: - Demand: ( ) ( ) - Inverse Demand: ( ) - Profits of firm i if unit cost is c: - Firm i chooses - Reaction function of firm i: - There is strategic substitutability in quantities.
o An increase in the output of the competitor reduces the output of the firm o An aggressive action of the rival elicits a soft action by the firm.
to maximize ( ( ) ) : ( ) Cournot equilibrium: Monopoly solution: Perfect competition: With n symmetric firms: ( ) ( ) ( ) ( ( ) ) ( ( ) ) So as n∞, Cournot model converge to perfect competition. (Firms’ profits and mark-ups are decreasing with the number of firms).
- Asymmetric Cournot: Can be asymmetric by varying their MC (Firms with lower costs obtain larger market share and higher profits. This fact justifies the investment in R&D: 4 - Enables firms to increase efficiency (reduce MC).
The benefits of reducing the cost will depend on the size of the market (demand) and the intensity of competition (number of firms).
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