Lecture unit 4: Markets and competitive analysis (1/2)

Question 1

When are firms competitors?

Answer 1

If one firm’s strategic choice adversely affects the performance of another

Question 2

Where (market) can competitors of a company be?

Answer 2

A firm may have competitors in several input markets and output markets at the same time

Question 3

What are direct and indirect competitors?

Answer 3

• 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

Question 4

What are the “practice” saying about competitors?

Answer 4

In practice, anyone who produces a substitute product is a competitor

Question 5

What is the SSNIP?

Answer 5

= 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

Question 6

When are two products close substitutes?

Answer 6

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

Question 7

What are “performance characteristics”?

Answer 7

Performance characteristics describe what the product does to the customer:

Example from the automobile industry: seating capacity, curb appeal, power and handling, reliability

Question 8

What is menat with Occasion for use? Substitute characteristic

Answer 8

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

Question 9

What is cross price elastiticty of demand?

Answer 9

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

Question 10

What are the two steps in identifying competitors in geographical areas?

Answer 10

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

Question 11

What does market structure refers to?

Answer 11

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.

Question 12

How are markets usually described?

Answer 12

markets are often described by the degree of concentration

Question 13

What is the “Structure, conduct, Performance paradigm”?

Answer 13

= 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.

Question 14

What are the four classes of market structure? Defined in Herfindahl index

Answer 14

• Perfect competition: Herfindals < 0.2
• Monopolistic competition: <0.2
• Oligopoly: 0.2 to 0.6
• Monopoly: >0.6

Question 15

What is the intensity of price competition for the 4 classes of market structure?

Answer 15

1. Perfect competition: fierce
2. Monopolistic competiton: depends on the degree of product differentiation
3. Oligopoly: depends on inter-firm rivalry
4. Monopoly: light unless there is threat to entry

Question 16

Characteristics of perfect competition?

Answer 16

• 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)

Question 17

What are the conditions for “fierce price competition”? ( how many conditions need to be fulfilled?]

Answer 17

when two or more conditions are met:

• there are many sellers
• customer perceive the product to be homogenous
• There is excess capacity

Question 18

Why might a low-cost producer set a low price even in a profitable industry?

Answer 18

• A low-cost producer may prefer to set a low price to maintain competitiveness

Question 19

What makes it harder to create and sustain cartels and collusive agreements?

Answer 19

The presence of many sellers

Question 20

What might small players do in perfect competition market?

Answer 20

• Small players will be tempted to cheat and small cheaters may go
  undetected

Question 21

Perfect competiton: What are three sources of increased revenue when price is lowered?

Answer 21

• customers buy more
• New customers buy
• Customers switch from the competitors

Question 22

What does “homogeneous products and excess capacity” imply in perfect competition?

Answer 22

• Products are indistinguishable between firms, and
• excess capacity means more supply is available than the demand at current prices, often leading to lower prices

Question 23

Why might a firm price below average cost in perfect competition?

Answer 23

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

Question 24

What happens when there is industry-wide excess capacity? (Perfect competition)

Answer 24

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

Question 25

What are the characteristics of a monopoly? (Competion, demand curve, price setting)

Answer 25

- 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

Question 26

How might a monopolist succeed and benefit consumers?

Answer 26

- 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

Question 27

Why are monopoly more innovative than in perfect competition and what’s the impact on consumers?

Answer 27

**Monopolists** are l**ikely 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.

Question 28

What are the 2 imporant **features** important to understand **pricing** in **monopolistic competition** ?

Answer 28

**Monopolistic competition** is marked by - **many** **sellers** who - they believe that their **actions** will **not materially affect** their competitors

Question 29

How do consumers choose products in **monopolistic competition** and what is the **slope of the demand curve**?

Answer 29

- 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.

Question 30

What is vertical and horizontal differentiation?

Answer 30

- **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**

Question 31

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?

Answer 31

- Consumers **choose** the store based on **“transportation costs”** - Transportation costs **prevent switching** for **small** differences in price

Question 32

What does **transportation cost** do? (horizontal differentiation)

Answer 32

Transportation costs **prevent switching** for **small** differences in price

Question 33

What is idiosyncartic preferences, also in context of horizontal differentiation?

Answer 33

=refer to the **unique, individual tastes** and **preferences** that vary widely from person to person -->**Horizontal** differentiation is **possible** with idiosyncratic preferences

Question 34

What are important sources for **idiosyncratic preferences?**

Answer 34

-->**Location and Taste** are important sources of **idiosyncratic preferences** -->**Horizontal** differentiation is **possible** with idiosyncratic preferences

Question 35

On what does the **degree of horizontal differentiation** depend upon? and what is it?

Answer 35

depends on the **magnitude of consumers’ search costs** **Search costs:** costs of finding information about alternatives

Question 36

What do **low cost sellers** try to do ? (monopolistic competition)

Answer 36

- **Low cost sellers** try to **lower** the **search costs** to **boost their market shares** (example: advertising)

Question 37

What happens when there is **low search costs**? (**Effect on Differentiation, prices**) Example market with **high search cost**?

Answer 37

- **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**

Question 38

At **which level is pricing** typically set in **monopolistic competition**?

Answer 38

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

Question 39

Monopolistic competition: How cann a firm earn economic profit, if the **price is above marginal costs**?

Answer 39

if price also **exceeds** **average** costs -->it allows firms to earn **economic profit**

Question 40

What **effect does economic profi**t have on **market entry** in monopolistic competition?

Answer 40

**Economic profits** attract **new** **entrants** into the market, -->continuing **until** economic **profits for existing firms are eroded to zero**

Question 41

How does **new entry affect incumbents** in a market characterized by **monopolistic competition?**

Answer 41

- 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

Question 42

Monopolistic competition: When does the entry of new firms **not lower prices**?

Answer 42

if the products are **highly differentiated**

Question 43

Under which circumstances is the **economic profit erosion** a**quicker** in **monopolistic competition with market entry?**

Answer 43

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**

Question 44

How does market exit affect remaining firms in monopolistic competition?

Answer 44

- **Exit by some firm**s can help restore **profitability** for the remaining firms

Question 45

How does **customer loyalty** influence **pricing and market entry** in monopolistic competition?

Answer 45

- **Customer loyalt**y allows **prices** to **exceed marginal** costs, and - this encourages market **entry**

Question 46

When is **entry** considered excessive in monopolistic competition?

Answer 46

Entry is considered excessive: - when it leads to **increased fixed cost**s - without a corresponding **reduction in prices**

Question 47

When is the **entry** in monopolisti markets **not excessive**?

Answer 47

If entry **increases the variety** of **products** that is **valued** by **customers**

Question 48

What is the difference between the demand curves of **monopolistic competition** and **perfect competition**

Answer 48

- This **differentiation results** in **each firm** having a **downward-sloping** demand curve **unlike** the **flat demand curve in perfect competition**, allowing some pricing power.