Competitors and Competition

Abhijit Sharma
Economics of Industry: Lecture 7
MAN0201M

Lecture overview
This lecture will cover:
Competition and competitors "
Market structure"
Qualitative and quantitative measures"
Substitutes and their characteristics"
Concentration ratios and Herfindahl index"

Characteristics of PC, MC, MP and O"

Evidence on on competition and
performance"
Reference: Besanko et al. Ch 8."

Competition
If a firms strategic choice adversely affects the
performance of another firm they are
competitors.
Firm can have competitors in input and output
markets simultaneously.
Competition can be direct or indirect.
Direct and indirect competitors
Direct competitors: Strategic choice of one firm
directly affects the performance of the other.
Indirect competitors: Strategic choice of one firm
affects the performance through the strategic
reaction by a third firm.
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Identifying competitors
Merger with all competitors should lead
to a small but significant nontransitory increase in price.
Small: At least 5%
Non-transitory: At least for one year

In practice, any one who produces a

substitute product is a competitor.

Characteristics of substitutes
Two products are close substitutes if they
have similar performance characteristics.
have similar occasion for use.
are sold in the same geographic area.

Empirical approaches to competitor

identification

Cross price elasticity of demand.

Pattern of price changes over time.
Product characteristics.
Products belonging to same genre or same
SIC need not be substitutes.
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Cross Price Elasticity

yx =

Q y / Q y
Px / Px

If yx is positive, consumers
purchase more of Y when the
price of X increases
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Characteristics of substitutes 2
Occasion for use
Products may share characteristics but differ in use
Orange juice & tea: both beverages but use may differ.
Another example: Hiking shoes versus football shoes.
Geographic area
Identical products in two different geographic markets:
not substitutes due to transportation costs.
Bulky products (e.g. cement) cannot be transported
over long distances to benefit from geographic price
difference.
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Market structure

Markets can be described by degree of

concentration.
Monopoly: extreme form, with highest
concentration and one seller.
Perfect competition: other extreme, with
innumerable sellers.
Covered already in MAN0101 - Business
Economics.
Recap: consult Begg and Ward - Economics
for Business, McGraw Hill.
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Measuring market structure

Common measures of concentration:
N-firm Concentration Ratio: combined market
share of largest N firms.
E.g. C5 is the five firm concentration ratio: the
share of five largest firms within an industry as
a ratio of the total market size.
Herfindahl Index: measures concentration as
the sum of squared market shares of firms.
Entropy: another measure of concentration
Covered in last weeks lecture.
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Four classes of market structure

Structure

Herfindahl
Index

Intensity of price
competition

Perfect
competition (PC)

Usually < 0.2

Fierce

Monopolistic
competition
(MC)
Oligopoly (O)

Usually < 0.2

Depends on degree of
product differentiation"

0.2 to 0.6

Depends on inter-firm
rivalry"

Monopoly (MP)

> 0.6

Low, unless there is

threat of entry"

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Example: Herfindahl Index and Concentration Ratios

Scenario one: 5 firms with 15% market share each.
Scenario two: one firm with 55% market share and four
firms with 5% market share each.
Concentration ratios (CR):
S1: C5 = (15+15+15+15+15)/100=0.75
S2: C5 = (55+5+5+5+5)/100=0.75
Herfindahl Index (HI):
S1: HI = (0.15)2+(0.15)2+(0.15)2+(0.15)2+(0.15)2 =0.1125
S2: HI = (0.55)2 +(0.05)2 +(0.05)2 +(0.05)2 +(0.05)2
=0.3125
Lower HI implies more intense price rivalry. Clearly there
is more intense competition in S1. Identical CRs.
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Measuring market structure:

Example
Consider commercial airline manufacturing:
What would be the C2 ratio in commercial
passenger jet manufacturing?

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Market structure and

competition
Monopolies may produce similar outcomes
as a competitive market (for instance,
through a credible threat of entry).
A market with as few as two firms can lead
to fierce competition (e.g. Word
processing/ spreadsheets - Schmalensee
type winner takes all markets).
With monopolistic competition, how well
differentiated the products are will
determine the intensity of price
competition.
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Perfect competition (PC)

Many sellers, selling homogenous product;
many well informed buyers.
Consumers shop around costlessly; sellers
can enter and exit costlessly.
Each firm faces infinitely elastic demand.
With perfect competition, pure economic
profits go to zero.
Percentage contribution margin PCM equals

where P and MC are price and marginal cost

respectively.
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Monopoly (MP)
Monopolist faces little or no competition in the
market.
Largely unconstrained in setting price.
If some fringe firms exist, their decisions do not
materially affect the monopolist s profits.
Monopolist sets the price so that marginal revenue
equals marginal cost (thus maximising profit).
Monopolist s price is above the marginal cost and
its output is below the competitive level.
The traditional anti-trust view is that limited output
and higher prices hurt the consumer.
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Monopoly and innovation

Monopolies often arise through more efficient
production or by better meeting consumers needs.
Consumers may benefit in some monopoly
situations: e.g. natural monopolies and decreasing
average costs (AC).
Monopolists are more likely to be innovative (than
firms facing perfect competition) since they can
capture some of the benefits of successful
innovation: e.g. big pharma such as GSK.
Since consumers also benefit from these
innovations, they are hurt in the long run if the
monopolist s profits are restricted.
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Monopolistic competition (MC)

Many sellers who believe their actions will not
materially affect competitors.
Each seller sells a differentiated product.
Unlike PC, in monopolistic competition each
firm s demand curve is downward sloping,
rather than flat.
Customer loyalty allows prices to exceed
marginal cost and encourages entry.
Entry is considered excessive if fixed costs go
up due to entry, without a reduction in prices.
If entry increases variety valued by customers,
then entry is not considered excessive.
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Vertical and horizontal

differentiation
Vertically differentiated products clearly differ in quality.
Horizontally differentiated products vary in certain product
characteristics (appealing to different consumers).
Tastes are sources of idiosyncratic preferences leading
to horizontal differentiation.
Another source: geographical location
Newsagents/ corner shops attract clientele based on
location.
Consumers choose supermarkets based on
transportation costs, which prevent switching for
small differences in price.
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Switching costs
Search costs discourage switching when prices are raised.
Demand switching is less likely when:
Customer preferences are idiosyncratic.
Customers not well informed about alternatives.
Customers face high transportation costs.

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Monopolistic competition and entry

Price is set above marginal cost (downward

sloping demand curve).
If P>AC, firm earns economic profit.
Economic profits attract new entrants until
each firms economic profit is zero.
With price competition (products not well
differentiated) economic profits quickly
erode.
Even if entry does not lower prices (highly
differentiated products), new entrants will
take away market share.
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Oligopoly (O)
Market has a small number of sellers.
Pricing and output decisions by each firm affects
the price and output in the industry.
E.g. military and commercial airplane
production/ automobile industry.
Oligopoly models (Cournot & Bertrand) focus on
how firms react to each other s moves.
We are not covering Cournot & Bertrand models
in detail.
Cournot & Bertrand models are left as
starred readings i.e. optional, but not
required for the course.
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Some evidence
Price-cost margins and concentration
Theory would predict higher price-cost margins
in industries with greater concentration (fewer
sellers).
Other reasons for inter-industry variation in
price-cost margins include regulation and
concentration of buyers.
Concentration and price: Evidence
For several industries, prices are found to be
higher in markets with fewer sellers.
US: In markets where the top three petroleum
retailers had sixty percent share, prices were
5 percent higher compared to markets where
the top three had a fifty percent share.
For service providers such as dentists and
physiotherapists, three sellers are enough to
create intense price competition.

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Some evidence: 2
Economies of scale and concentration
Industries with large minimum efficient scales compared
to market size tend to have high concentration.
This inter-industry pattern of concentration is replicated
across countries.
When production/ marketing enjoys economies of scale,
entry is difficult and hence profits are high.
Concentration and profitability
Concentration and profitability don t seem to have a
strong relationship.
Possible explanations:
Differences in accounting practices may hide the
differences in profitability.
Small number of sellers may imply inherently
unprofitable nature of the business.
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Lecture summary
We have considered:
Competition, competitors and
concentration.
Theoretical expectations and evidence.
Market structure and firm performance.
Characteristics of PC/ MC/ MP/ O.
Relevant examples.
Many of these ideas will link directly to the
following lecture on pricing.
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