Week 5 - Market Structure and Competition

Question 1

What is the first step to shaping business strategies?

Answer 1

Identifying the competitors (as well as the market).

Question 2

What are competitors?

Answer 2

They are the firms whose strategic choices directly affect one another

• For example: if Mercedes reduced the price on its sports coupe, BMW would have to consider a pricing response.
• Audi, BMW and Mercedes are considered as competitors in the luxury car market.

Question 3

How is strategic dependence related to the economic concept of substitutes?

Answer 3

In general, 2 products X and Y are substitutes if, when the price of X increases, and the price of Y stays the same, purchases of X go down and purchases of Y go up.

Question 4

When do products tend to be close substitutes?

Answer 4

• They have the same or similar product performance characteristics
• They have the same or similar occasions for use
• They are sold in the same geographic market.

Question 5

What does cross-price elasticity of demand measure?

Answer 5

It measures the degree to which products substitute for each other.
- If the products in question are X and Y; then the cross-price elasticity measures the percentage change in demand for Y that results from a 1 percent change in the price of X.

Question 6

How are markets often characterised?

Answer 6

According to the degree of seller concentration. This permits a quick and reasonably accurate assessment of the likely nature of competition.

Question 7

What does market structure refer to?

Answer 7

The number and distribution of firms in a market. Based on the degree of competition, the structure of the market can be divided into four types:

• Perfect competition
• Monopolistic competition
• Oligopoly
• Monopoly

Question 8

What is a perfect competition?

Answer 8

• Many sellers
• Consumers perceive the product to be homogenous
• Many well-informed consumers who can costlessly shop around for the best price
• There is excess capacity
• No barriers to entry or exit
• E.g. commodities such as oil, food

Question 9

What is a monopolistic competition?

Answer 9

• Many sellers offering differentiated products (branded)
• There are a few barriers to entry and exit
• E.g. Small restaurants, shops, trades

Question 10

What is an oligopoly?

Answer 10

• Only a few sellers in the market (normally up to 15)
• Many restrictions to entry and exit
• Differentiated (branded)
• E.g. financial services, supermarkets

Question 11

What is a monopoly?

Answer 11

• A firm (monopolist) faces little or no competition in its output market.
• High barriers to entry and exit (or blocked totally)
• Offers unique products
• E.g. government services, utilities

Question 12

What are the 2 measures of market structure?

Answer 12

• The N-firm concentration ratio and

- The Herfindahl index

Question 13

What is the N-firm concentration ratio (CR)?

Answer 13

It is the combined market share of the N largest firm in the market.

Question 14

What is on problem with the CR measure?

Answer 14

What is on problem with the CR measure?
It is invariant to changes in the sizes of the largest firm.
e.g. a 5-firm concentration ratio, CR(5), does not change value if the largest firm gains 10% at the expense of the second largest firm, even though this could make the market less competitive (we use the H index to solve this problem).

Question 15

What is the Herfindahl Index?

Answer 15

It equals the sum of the squared market shares of all the firms in the markets.

Question 16

Perfect competition curves summarised:

Answer 16

• MR/D/AR/P is on the same horizontal line
• AC is an upside down umbrella
• MC is the Nike symbol
• A perfectly competitive market in equilibrium occurs when AC = MC and = P = D= MR = AR

When AC is below the MR/D/AR/P line this results in profit.
When AC is above the MR/D/AR/P line this results in loss (which cannot be sustained for long).

Question 17

Monopoly curves summarised:

Answer 17

• D = AR is downward sloping
• MR is below D (has acute angle between them)
• AC is upside down umbrella
• MC is Nike symbol and goes through MR, AC (at its min) and D=AR

To maximise profit, the price is set at MR = MC

• Qm dotted line goes through where MR and MC intersect
• Pm dotted line hits D=AR line where Qm hits it
• AC dotted line hits AC curve where Qm hits it

Question 18

What does the notion of product differentiation capture?

Answer 18

Products A and B are differentiated if there is some price at which some consumers prefer to
purchase A and others prefer to purchase B. The notion of product differentiation captures the idea
that consumers make choices among competing products on the basis of factors other than just
price.

Question 19

What is the difference between vertical and horizontal differentiation?

Answer 19

• Vertical Differentiation. A product is vertically differentiated when it is unambiguously better or worse than competing products.
• Horizontal Differentiation. A product is horizontally differentiated when only some consumers prefer it to competing products (holding price equal).
  o One important source of horizontal differentiation is geography.