Lecture unit 4: Markets and competitive analysis (1/2) Flashcards
When are firms competitors?
If one firm’s strategic choice adversely affects the performance of another
Where (market) can competitors of a company be?
A firm may have competitors in several input markets and output markets at the same time
What are direct and indirect competitors?
- Direct competitors: strategic choices of one firm directly affect the performance of the other
- Indirect competitors: strategic choices of one firm affect the performance of the other because of a strategic reaction by a third firm
What are the “practice” saying about competitors?
In practice, anyone who produces a substitute product is a competitor
What is the SSNIP?
= Merger with all the competitors should lead to a small but significant non-transitory increase in price (SSNIP)
–>Small: at least 5%
- non-transitory: at least for one year
When are two products close substitutes?
Two products tend to be close substitutes when
- they have similar performance characteristics,
- they have similar occasion for use, and
- hey are sold in the same geographic area
What are “performance characteristics”?
Performance characteristics describe what the product does to the customer:
Example from the automobile industry: seating capacity, curb appeal, power and handling, reliability
What is menat with Occasion for use? Substitute characteristic
Products may share characteristics but may differ in the way they are used.
Examples:
* Orange juice and cola are beverages but used in different
occasions.
* Hiking shoes versus court shoes
What is cross price elastiticty of demand?
Cross price elasticity of demand:
When nyx is positive, it indicates that consumers increase their purchase of good Y as the price of good X increases
What are the two steps in identifying competitors in geographical areas?
Step 1: locate the catchment area (where the customers come from)
Step 2: find out where the residents of the catchment area shop
With some products like books and drugs being sold over the internet identifying geographic competition becomes more
difficult
What does market structure refers to?
Market structure refers to the number and distribution of firms in a market
- Monopoly is one extreme with the highest concentration (one seller)
- Perfect competition is the other extreme with innumerable sellers.
How are markets usually described?
markets are often described by the degree of concentration
What is the “Structure, conduct, Performance paradigm”?
= it stats that the structure of a market can profoundly affect the conduct and financial performance of its firms;
–>the causal connection is known as the Structure, Conduct, Performance paradigm.
What are the four classes of market structure? Defined in Herfindahl index
- Perfect competition: Herfindals < 0.2
- Monopolistic competition: <0.2
- Oligopoly: 0.2 to 0.6
- Monopoly: >0.6
What is the intensity of price competition for the 4 classes of market structure?
- Perfect competition: fierce
- Monopolistic competiton: depends on the degree of product differentiation
- Oligopoly: depends on inter-firm rivalry
- Monopoly: light unless there is threat to entry
Characteristics of perfect competition?
- Many sellers who sell a homogenous good
- Many well informed buyers
- Consumers can costlessly shop around
- Sellers can enter and exit costlessly
- Each firm faces infinitely elastic demand
- With perfect competition economic profits go to zero (zero profit condition)
- When profits are maximized percentage contribution margin
PCM = 1/η = 0 (η is the elasticity of demand & = infinity)
What are the conditions for “fierce price competition”? ( how many conditions need to be fulfilled?]
when two or more conditions are met:
- there are many sellers
- customer perceive the product to be homogenous
- There is excess capacity
Why might a low-cost producer set a low price even in a profitable industry?
- A low-cost producer may prefer to set a low price to maintain competitiveness
What makes it harder to create and sustain cartels and collusive agreements?
The presence of many sellers
What might small players do in perfect competition market?
- Small players will be tempted to cheat and small cheaters may go
undetected
Perfect competiton: What are three sources of increased revenue when price is lowered?
- customers buy more
- New customers buy
- Customers switch from the competitors
What does “homogeneous products and excess capacity” imply in perfect competition?
- Products are indistinguishable between firms, and
- excess capacity means more supply is available than the demand at current prices, often leading to lower prices
Why might a firm price below average cost in perfect competition?
When firms operate below their full capacity:
- they can afford to lower prices temporarily below their average total cost
- To cover only variable costs when operating below full capacity
Only if they are operating below full capacity – otherwise they are not able to satisfy the increased demand by the lower prices
What happens when there is industry-wide excess capacity? (Perfect competition)
Prices may fall below average costs,
- leading some firms to exit the market if they continuously incur losses
- if exit is not an option, excess capacity and losses will persist for a while
What are the characteristics of a monopoly? (Competion, demand curve, price setting)
- A monopolist faces little or no competition in the output market.
- If some fringe firms exist, their decisions do not materially affect the monopolist’s profits.
- A monopolist faces a downward sloping demand curve (can set prices with little regard to how other firms will respond).
- The monopolist sets the price so that marginal revenue equals marginal costs.
- Thus the monopolist’s price is above the marginal costs and the output is below the competitive level
How might a monopolist succeed and benefit consumers?
- A monopolist often becomes dominant by producing more efficiently or better meeting consumer needs than competitors,
- potentially making consumers net beneficiaries as they receive superior products or services
Why are monopoly more innovative than in perfect competition and what’s the impact on consumers?
Monopolists are likely more innovative than firms in perfect competition because
- they can retain a significant portion of the profits from their innovations
- This innovation benefits consumers,
- who might suffer in the long run if these profits are excessively restricted, potentially discouraging further innovation.
What are the 2 imporant features important to understand pricing in monopolistic competition ?
Monopolistic competition is marked by
- many sellers who
- they believe that their actions will not materially affect their competitors
How do consumers choose products in monopolistic competition and what is the slope of the demand curve?
- Each firm offers a differentiated product, leading consumers to choose based on more than just price (on the basis of other factors)
- This differentiation results in each firm having a downward-sloping demand curve unlike the flat demand curve in perfect competition, allowing some pricing power.
What is vertical and horizontal differentiation?
- Vertically differentiated products unambiguously differ in quality
- Horizontally differentiated products vary in certain product characteristics to appeal to different consumer groups
An important source of horizontal differentiation is geographical
location
What is the situation if you have 2 grocery stores that are located at different locations: On which bases do consumers choose the stores? And what is it?
- Consumers choose the store based on “transportation costs”
- Transportation costs prevent switching for small differences in price
What does transportation cost do? (horizontal differentiation)
Transportation costs prevent switching for small differences in price
What is idiosyncartic preferences, also in context of horizontal differentiation?
=refer to the unique, individual tastes and preferences that vary widely from person to person
–>Horizontal differentiation is possible with idiosyncratic preferences
What are important sources for idiosyncratic preferences?
–>Location and Taste are important sources of idiosyncratic preferences
–>Horizontal differentiation is possible with idiosyncratic preferences
On what does the degree of horizontal differentiation depend upon? and what is it?
depends on the magnitude of consumers’ search costs
Search costs: costs of finding information about alternatives
What do low cost sellers try to do ? (monopolistic competition)
- Low cost sellers try to lower the search costs to boost their market shares (example: advertising)
What happens when there is low search costs? (Effect on Differentiation, prices)
Example market with high search cost?
- Low search costs reduce horizontal differentiation leading to lower prices and lower profits to all firms
- Market with high search costs: physiciations have high search costs
At which level is pricing typically set in monopolistic competition?
since each firm faces a downward-sloping demand curve,
- the price will be set above marginal costs
- allowing for potential economic profits if price also exceeds average costs
Monopolistic competition: How cann a firm earn economic profit, if the price is above marginal costs?
if price also exceeds average costs
–>it allows firms to earn economic profit
What effect does economic profit have on market entry in monopolistic competition?
Economic profits attract new entrants into the market,
–>continuing until economic profits for existing firms are eroded to zero
How does new entry affect incumbents in a market characterized by monopolistic competition?
- New entrants decrease market share for incumbents,
- reducing their revenue and economic profit, regardless of whether or not entry affects prices directly
—>if highly differentiated products: than entry does not lower prices
Monopolistic competition: When does the entry of new firms not lower prices?
if the products are highly differentiated
Under which circumstances is the economic profit erosion aquicker in monopolistic competition with market entry?
Generally: the drop in revenue caused by entry will reduce the economic profit:
If there is price competiton -> less differentiated products, the erosion will be quicker
How does market exit affect remaining firms in monopolistic competition?
- Exit by some firms can help restore profitability for the remaining firms
How does customer loyalty influence pricing and market entry in monopolistic competition?
- Customer loyalty allows prices to exceed marginal costs, and
- this encourages market entry
When is entry considered excessive in monopolistic competition?
Entry is considered excessive:
- when it leads to increased fixed costs
- without a corresponding reduction in prices
When is the entry in monopolisti markets not excessive?
If entry increases the variety of products that is valued by customers
What is the difference between the demand curves of monopolistic competition and perfect competition
- This differentiation results in each firm having a downward-sloping demand curve unlike the flat demand curve in perfect competition, allowing some pricing power.
