Lecture 3 - Market and Competitive Analysis

Question 1

Define the terms:

Direct Competitors

Indirected Competitors

Answer 1

Direct competitors: Strategic choice of one firm directly affects the performance of the other.

Indirect competitors: Strategic choice of one firm affects the performance of the other because of a strategic reaction by a third firm.

Question 2

What is industry concentration?

Answer 2

• Concentration measures the extent to which a few firms control an industry.
• Other things being equal, a market is said to be more concentrated
  
  • the fewer the number of firms in production, or
  • the more unequal the distribution of market shares.
• Unilateral or coordinated action to increase prices and lower output - ( so firms decide together how to increase/lower prices for their general benefit)
  *

Question 3

Explain the concentration ratio (CR_r).

Answer 3

• The goverment doesn’t like firms having really large concentration ratios so if firms are to buy a new business they have to sell off another part to keep the same market share. (called competition commission must be informed).

Question 4

Explain the Herfindahl index

Answer 4

Question 5

What attributes are used to indintify if other firms are competitors or not?

Answer 5

• In practice anyone who produces a substitute product is a competitor
• Two products tend to be close substitutes when
  
  • they have similar performance characteristics
  • they have similar occasion for use and
  • they are sold in the same geographic area

Question 6

What are issues of studying competition using SIC codes.

Answer 6

• Based of a manufacturing industry based world where different firms produced different products.
• However, companies such as amazon are branching out into different industries meaning based on the SIC codes they aren’t taking too much of a market share but overall they are taking a hugo percentage.
• Technology developments blurring industry borders.
• SIC = standard industry classification

Question 7

What are the four classes of market structure?

Give each class the Herfindahls measure and the intensity of price competition experienced.

Answer 7

Question 8

What are the assumptions behind a perfectly competitive market?

Answer 8

• Large (theoretically infinite) number of consumers and suppliers each with an insignificant share of market
• Each firm is too small to affect price via a change in market supply - each individual firm is assumed to be a price taker
• Identical output produced by each firm – homogeneous products that are perfect substitutes for each other (Consumers perceive the products to be identical)
• Consumers have perfect information about the prices all sellers in the market charge
• All firms (industry participants and new entrants) have equal access to resources (technology, other factor inputs)
• No barriers to entry & exit of firms

Question 9

What is the point of the model of a perfectly competitive market, when it never really exists?

Answer 9

The model provides a theoretical benchmark against which we compare and contrast imperfectly competitive markets - point of reference

Question 10

Draw the competitive firms demand curve.

Answer 10

Question 11

Illustrate profit-maximisation in perfect competition. (Draw a graph)

Answer 11

(remember this is the firms short term goal because in reality perfetly competition price is driven down to Price = ATC)

Question 12

What is a monopoly?

Answer 12

• Monopoly is the extreme opposite of perfect competition – just a single supplier.
• In most industries the situation lies between perfect competition and monopoly, but firms try to create monopolistic positions.
• Key characteristic of monopoly is that the market for the firm and the industry demand are the same thing. - because monopoly is the only firm in the market
• Monopolist will equate its MC curve with the market MR curve to get to a position of maximum profits.

Question 13

Illustrate how monopolies try to maximise profits.

Answer 13

• Monopolies reduce supply and increase price to maximise their profits (point of minimum MC) in expense of the customers. This is why the government wants to make sure there is sufficient competiton in the market place.

Question 14

What are reasons for/against monopolies?

Answer 14

• Against
  
  • The standard case against a monopoly is that these businesses can earn abnormal profits at the expense of economic efficiency
  • The monopolist is extracting a price from consumers that is above the cost of resources used in making the product
  • There is a deadweight loss as the price of the product increases and is being under-consumed.
• For
  
  • However, monopolist might be more innovative and hence benefit the consumer.
  • Look at Google -> giving them monopoly power -> leads to innovation and new products and services.

Question 15

Illustrate and explain the U-shape relationship between innovation and competition.

Answer 15

• Escape Competition Effect:
  
  • innovate more to escape the competition.
• Schumpeterian effect:
  
  • Even if firms innovates these will be dissipated away by competitors (e.g. copying or coming up with better innovations) and hence incentive to innovate declines.

Question 16

What are the features of an oligopoly market.

Answer 16

• A market dominated by a few large firms i.e. “Competition amongst the few”
• High level of market concentration
• Entry barriers exist – long run supernormal profits
• Mutual interdependence between competing firms i.e. the price and output decisions of one firm affects itself and others
• Intensive non-price competition is a common feature of oligopoly
• Periodic aggressive price wars (fights for market share /dominance)
• Strong tendency for many market structures to tend towards oligopoly in the long run - Coke and Pepsi an example of oligopoly

Question 17

Explain the prisonners dilemma in duopolys.

Answer 17

• The optimum solution is for both firms to sell at £200 (Nash equilibrium) this means no other firms will come and try to undercut them.
• Parato Optimum: both firms would have been maximum profits setting at £300 together. (could lead to outside firms undercutting them.)

Question 18

Explain the cournot model is and its assumptions.

Answer 18

• The assumption of the Cournot model is that each firm maximises its profit on the assumption that the other firm’s output is fixed.
  
  • Each firm chooses a quantity of output instead of a price.
  • In choosing an output, each firm takes its rival’s output as given.
• In the Cournot model each of the two firms pick the quantities Q1 and Q2 to be produced
• The price that emerges clears the market (demand = supply)

Question 19

In a Cournot Duopoly explain how the reaction function of one of the firms is derived.

Answer 19

Question 20

Illustrate the Cournot equilibrium for two firms. (Draw a graph)

Answer 20

Question 21

Explain how the Cournot Model converges to perfect competition as the number of firms increase in the market.

Answer 21

• The output in Cournot equilibrium will be less than the output under perfect competition but greater than under joint profit maximising collusion
• In the Nash equilibrium of this general version of the Cournot model, firms fail to maximize their joint profit.
• Relative to joint profit maximisation, firms produce too much output in the Nash equilibrium (joint profit maximisation is when firms collude an act like a monopolist).
• With only one firm in the market, the Cournot-Nash equilibrium is the monopoly equilibrium.
• As the number of firms increases, output increases. As a result, price and aggregate oligopoly profits decrease.
• When there are infinitely many firms, the Cournot model is, in effect, the perfectly competitive model.

Question 22

What is the Betrand paradox?

How is the paradox avoided?

Answer 22

• If the firms can adjust the output quickly, Bertrand type competition will ensue.
• In Bertrand competition two firms are sufficient to produce the same outcome as infinite number of firms
• The Bertrand model with two firms is perfectly competitive (The Bertrand paradox).
• The Betrand model will move away from a perfectly competitive model when we start relaxing assumptions one period to many periods, homogeneous products to product differentiation, fixed number of firms to entry/exits.

Question 23

Define collusion (generally)

Answer 23

Collusion represents an attempt by firms to recognise their interdependence and act together rather than compete – seen as a move towards joint-profit maximization.

Question 24

Define overt collusion

Answer 24

• Creation of a price fixing arrangement with a producer cartel responsible for allocating output / supply within the market (eg., OPEC)

Question 25

What is tacit collusion?

Answer 25

• Tacit collusion
  
  • Dominant firm ‘price leadership’: leading firm’s price changes are matched by the other firms. E.g. Sainsburies following the prices Tesco sets
  • Barometric-firm leadership: price leader the one judged to have best knowledge of prevailing market conditions.

Question 26

What is horizontal collusion?

What is vertical collusion?

Answer 26

• Horizontal collusion takes place between firms in the same industry (BA and Virgin Atlantic in terms of prices).
• Vertical collusion could be forward into distribution channels (brewers’ control of pubs) or backward into supply sources (supermarket chains)

Question 27

What are some entry deterring strategies (e.g. found in oligopolies)?

Answer 27

• Aggressive price reductions to move down the learning curve
• Intensive advertising to create brand loyalty
• Acquiring patents
  
  • new processes are typically incremental improvements or reconfigurations of existing processes (Pilkington’s float glass process is revolutionary)
  • since processes cannot be easily viewed by competitors, secrecy is highly effective in protecting process innovations
  • product innovations are more visible and hence can be copied more easily by competitors
• Enhancing reputation for predation (e.g., suppliers and customers)
• Limit pricing – selling at price below average cost Holding or building excess capacity (Sumo strategy)
• Entry before competitors to discourage

Question 28

What are the effects of strategic commitment?

Answer 28

• Strategic commitments
  
  • have long run impact and
  • are hard to reverse
• Can affect choices made by rivals
• Assessing strategic commitments involves anticipating market rivalry
• Inflexibility can add value
• Strategic commitment limits options but alters competitors’ expectations
• Strategic commitment can make a simultaneous move game into a sequential move game

Question 29

Derive and explain the maths behind the Stackelberg model.

Answer 29

• Commitment can be explored in the Stackelberg game.

Question 30

Explain how the Stackelberg equilibrium model illlustrates how strategic commitment can enhance profits.

Answer 30

• Leader produces more than the Cournot equilibrium output.
  
  • Larger market share, high profits
  • First-mover advantage
• Follower produces less than the Cournot equilibrium output
  
  • Smaller market share, lower profits

Question 31

Explain the benefits/cons of preserving flexibility via a firm choosing to make commitments or not.

Answer 31

• The value of commitments lies in creating inflexibility
• However, when there is uncertainty, flexibility is valuable since future options are kept open
• Commitments can sacrifice the value of the options
• By waiting, a firm preserves its options value but it may also allow its competitors to make preemptive investments.

Question 32

What are real options?

Answer 32

• A real option is an alternative or choice that becomes available with a business investment opportunity.
• Real options have the principle that a firm has the right but not the obligation to exercise the option on the investment opportunity/asset.
• Real options can include opportunities to expand and cease projects if certain conditions arise, amongst other options.
• They are referred to as “real” because they usually pertain to tangible assets such as capital equipment, rather than financial instruments.
• Real options points to two major types of option: Flexibiity options and growth options.

Question 33

Discuss the two major types of option: Flexibility options and growth options

Answer 33

For strategy formulation, our primary interest is how we can use the principles of option valuation to create shareholder value. There are two types of real option:

• Growth options allow a firm to make small initial investments in a number of future business opportunities but without committing to them.
• Flexibility options relate to the design of projects and plants that permit adaptation to different circumstances - Flexible manufacturing systems allow different product models to be manufactured on a single production line.
• Individual projects can be designed to introduce both growth options and flexibility options. This means avoiding commitment to the complete project and introducing decision points at multiple stages, where the main options are to delay, modify, scale up, or abandon the project.

Question 34

In developing strategy, our main concern is with growth options. These might include:

Answer 34

• “Platform investments.” These are investments in core products or technologies that create a stream of additional business opportunities.15 3M’s investment in nanotechnology offers the opportunity to create new products across a wide range of its businesses, from dental restoratives and drug- delivery systems to adhesives and protective coatings. Google’s search engine has provided the platform for a wide variety of initiatives that range from other search products (Google Maps, Google Scholar) to advertising management products, to downloadable software.
• Strategic alliances and joint ventures, which are limited investments that offer options for the creation of whole new strategies.17 Virgin Group has used joint ventures as the basis for creating a number of new businesses: with Stagecoach to create Virgin Rail, with AMP to create Virgin Money (financial services), with Deutsche Telecom to form Virgin Mobile. Shell has used joint ventures and alliances as a means of making initial investments in wind power, biodiesel fuel, solar power, and other forms of renewable energy.
• Organizational capabilities, which can also be viewed as options offering the potential to create competitive advantage across multiple products and businesses. 18 Sharp’s miniaturization capability has provided a gateway to success in calculators, LCD screens, solar cells and PDAs.

Question 35

Explain why flexibility analysis and approach is key to strategic formulation.

Answer 35

• In a world of uncertainty, where investments, once made, are irreversible, flexibility is valuable.
• Instead of committing to an entire project, there is virtue in breaking the project into a number of phases, where the decision of whether and how to embark on the next phase can be made in the light of prevailing circumstances and the learning gained from the previous stage of the project.
• Most large companies have a phases and gates approach to product development in which the development process is split into distinct phases, at the end of which the project is reassessed before being allowed through the “gate.”
• Such a phased approach creates the options to continue the project, to abandon it, to amend it, or to wait.
• So as a project is embarked, the commitment should be modified as conditions evolve. A real option exists if future information can be used to tailor decisions. Key balancing ‘learn rate’ (receive new information to adjust strategy) versus ‘burn rate’ (irreversible commitments)
  *

Question 36

How can Game theory be helpful for strategic management?

Answer 36

• Help us understand business situations
• Provides a set of tools to structure our view of competitive interactions
• Provides a systematic framework for exploring dynamics of competition
• Provides a basis of changing the game and thinking through the likely outcomes of such changes.

Question 37

What are the limitations of game theory?

Answer 37

• Clear predictions in highly stylised situations involving few external variables and restrictive assumptions
• Lack of generality and analysis of dynamic situations through a sequence of static equilibrums.
• Could result in no equilibrium or multiple equilibrium for complex situations.
• Specifies all possible actions/strategies and does not allow for ambiguity
• Assumes similar strategic options but strategic management is about transforming competitive games through building positions of unilateral competitive advantage.
• Assumes that history, values and culture has little place in forming expectations of the competitor.