192 • Chapter 5 • Competitors and Competition
CHAPTER SUMMARY
The first step in analyzing competition is to identify competitors. Competitors in output markets sell products that are substitutes. Competitors in input markets buy inputs that are substitutes.
Generally, two sellers are competitors in an output market if their products are close substitutes, that is, have similar product-performance characteristics. Price elasticities are useful for determining whether a product has close substitutes.
Once a market is well defined, its structure may be measured using an N-firm concentration ratio or a Herfindahl index.
The structure of a market is often related to the conduct of the firms within it. The spectrum of competitive interaction ranges from competition and monopolistic competition to oligopoly and monopoly.
In competitive markets, consumers are extremely price sensitive, forcing sellers to set prices close to marginal costs. Markets with homogeneous products and many sellers are more likely to feature competitive pricing. Excess capacity exacerbates pricing pressures, often driving prices below average costs.
Monopolists have such a substantial share of their market that they ignore the pricing and production decisions of fringe firms. They may set prices well above marginal cost without losing much business.
Monopolistically competitive markets have many sellers, each with some loyal customers. Prices are set according to the willingness of consumers to switch from one seller to another—if consumers are disloyal and have low search costs, sellers may lower prices to steal business from their competitors. Profits may be eroded further by entrants.
Oligopolies have so few firms that each firm’s production and pricing strategy appreciably affects the market price. Market prices can be well above marginal costs, or driven down to marginal costs, depending on the interaction among oligopolists and the degree of product differentiation among them.
Many markets, including consumer goods markets, feature a small number of large firms that exploit economies of scale in marketing and several niche players.
Studies confirm that prices are strongly related to industry structure. Price–cost margins tend to be much lower in more competitive markets.
QUESTIONS
1.Why are the concepts of own and cross-price elasticities of demand essential to competitor identification and market definition?
2.In a recent antitrust case, it was necessary to determine whether grocers that specialize in natural and organic foods, such as Whole Foods and Wild Oats, constitute a separate market. How would you go about identifying the market served by these grocers? (The U.S. Federal Trade Commission unsuccessfully attempted to block the Whole Foods/Wild Oats merger.)
3.How would you characterize the nature of competition in the restaurant industry? Are there submarkets with distinct competitive pressures? Are there important
Questions • 193
substitutes that constrain pricing? Given these competitive issues, how can a restaurant be profitable?
4.How does industry-level price elasticity of demand shape the opportunities for making profit in an industry? How does the firm-level price elasticity of demand shape the opportunities for making profit in an industry?
5What is the “revenue destruction effect”? As the number of Cournot competitors in a market increases, the price generally falls. What does this have to do with the revenue destruction effect? Smaller firms often have greater incentive to reduce prices than do larger firms. What does this have to do with the revenue destruction effect?
6.How does the calculation of demand responsiveness in Linesville change if customers rent two videos at a time? What intuition can you draw from this about the magnitude of price competition in various types of markets?
7.Numerous studies have shown that there is usually a systematic relationship between concentration and price. What is this relationship? Offer two brief explanations for this relationship.
8.The relationship described in question 7 does not always appear to hold. What factors, besides the number of firms in the market, might affect margins?
9.The following are the approximate U.S. market shares of different brands of soft drinks: Coke—45% Pepsi—30% Dr. Pepper/7-Up—15% All other brands—10%.
a.Compute the Herfindahl for the soft-drink market. Suppose that Pepsi acquired Dr. Pepper/7-Up. Compute the post-merger Herfindahl. What assumptions did you make?
b.Federal antitrust agencies would be concerned to see a Herfindahl increase of the magnitude you computed in (a), and might challenge the merger. Pepsi could respond by defining the market as something other than soft drinks. What market definition might they propose? Why would this change the Herfindahl?
10. “The only way to succeed in a market with homogeneous products is to produce more efficiently than most other firms.” Comment. Does this imply that efficiency is less important in oligopoly and monopoly markets?
11. In what ways are monopolistically competitive markets “monopolistic?” In what ways are they “competitive?”
12. Adam and Catherine are choosing between two ice cream shops, Icy and Frosty, located at either end of a 1-mile-long beach. Adam is standing in front of Icy, while Catherine is standing in front of Frosty. Both Adam and Catherine are each willing to pay, at most, $6 for one ice cream cone. It costs them $1 to walk the 1-mile distance between the shops. Icy is government-run, so the price is fixed at exactly $4/cone and will not change. The shops face costs of $0.25/cone. What price should Frosty charge if it is to maximize its total profits from Adam and Catherine?
13. The large turbine generator industry is a duopoly. The two firms, GE and Westinghouse, compete through Cournot quantity setting competition. The demand curve for the industry is P 5 100 2 Q, where P is price (in $millions) and Q is the total quantity produced by GE and Westinghouse. Currently, each firm has marginal cost of $40 and no fixed costs. Show that the equilibrium price is $60, with each firm producing 20 machines and earning profits of $400.
194 • Chapter 5 • Competitors and Competition
14. The dancing machine industry is a duopoly. The two firms, Chuckie B Corp. and Gene Gene Dancing Machines, compete through Cournot quantity-setting competition. The demand curve for the industry is P 5 120 2 Q, where Q is the total quantity produced by Chuckie B and Gene Gene. Currently, each firm has marginal cost of $60 and no fixed costs.
a.What is the equilibrium price, quantity, and profit for each firm?
b.Chuckie B Corp. is considering implementing a proprietary technology with a one-time sunk cost of $200. Once this investment is made, marginal cost will be reduced to $40. Gene Gene has no access to this or any other costsaving technology, and its marginal cost will remain at $60. Should Chuckie B invest in the new technology? (Hint: You must compute another Cournot equilibrium.)
15. Consider a market with two horizontally differentiated firms, X and Y. Each has a constant marginal cost of $20. Demand functions are
Qx 5 100 2 2Px 1 1Py
Qy 5 100 2 2Py 1 1Px
Calculate the Bertrand equilibrium in prices in this market.
16. How do you think the equilibrium in question 15 will change if cross-price elasticities of demand increase? How would you alter the equations to show such an increase? Can you compute the new equilibrium?
ENDNOTES
1Indirect competitors may also include firms that are not currently direct competitors but might become so. This definition forces managers to go beyond current sales data to identify potential competitors.
2Capps, C., D., Dranove, and M. Satterthwaite, “Competition and Market Power in Option Demand Markets,” RAND Journal of Economics, 2003, 34(4), pp. 737–763.
3The index is named for Orris Herfindahl, who developed it while writing a Ph.D dissertation at Columbia University on concentration in the steel industry. The index is sometimes referred to as the Herfindahl-Hirschman index and is often abbreviated HHI.
4This was shown in the Economics Primer.
5Potash (potassium oxide) is a compound used to produce products such as fertilizer and soap. 6Chapters 5 and 6 of Markham, J., The Fertilizer Industry, Nashville, TN, Vanderbilt
University Press, 1958.
7We will assume that this offer does not require Deere to adjust the price at which it sells engines to its other customers.
8Fisher, F., Industrial Organization, Antitrust, and the Law, Cambridge, MA, MIT Press, 1991.
9Demsetz, H., “Two Systems of Belief about Monopoly,” in Goldschmidt, H. et al. (eds.),
Industrial Concentration: The New Learning, Boston, Little, Brown, 1974.
10Chamberlin, E. H., The Theory of Monopolistic Competition, Cambridge, MA, Harvard University Press, 1933.
11Recall that the optimal PCM 5 1/ . Thus, in this case, PCM 5 (P – 10)/P 5 .5. Solving for P yields P 5 $20.
12Cournot, A., “On the Competition of Producers,” Chapter 7 in Research into the Mathematical Principles of the Theory of Wealth, translated by N. T. Bacon, New York, Macmillan,
Endnotes • 195
1897. For an excellent review of the Cournot model and other theories of oligopoly behavior, see Shapiro, C., “Theories of Oligopoly Behavior,” Chapter 6 in Willig, R., and R. Schmalensee (eds.), Handbook of Industrial Organization, Amsterdam, North Holland, 1989.
13Aldrich, L., 2008, “Cattle-Market Psychology Shaken by Plant Closure,” The Wall Street Journal, 1/30/2008, p. B5A.
14Cournot’s assumption is actually a special case of a modeling assumption known as the Nash equilibrium, which is used to identify likely strategies in a variety of contexts. The Nash equilibrium is discussed in the Economics Primer.
15Profit 1 can be written as: 90Q1 2 Q12 2 Q2gQ1. If we treat Q2g as a constant and take the derivative of p1 with respect to Q1, we get 1/ Q1 5 90 2 2Q1 2 Q2g. Setting this deriva-
tive equal to 0 and solving for Q1 yields the profit-maximizing value of Q1.
16Porter, M., and A. M. Spence, “The Capacity Expansion Decision in a Growing Oligopoly: The Case of Corn Wet Milling,” in McCall, J. J. (ed.), The Economics of Information Uncertainty, Chicago, University of Chicago Press, 1982, pp. 259–316.
17Bertrand, J., “Book Review of Recherche sur Les Principes Mathematiques de la Theorie des Richesses,” Journal des Savants, 67, 1883, pp. 499–508.
18The idea that the Cournot equilibrium can (under some circumstances) emerge as the outcome of a “two-stage game” in which firms first choose capacities and then choose prices is due to Kreps, D. and J. Scheinkman, “Quantity Precommitment and Bertrand Competition Yield Cournot Outcomes,” Bell Journal of Economics, 14, 1983, pp. 326–337.
19Gasini, F., J. J. Lafont, and Q. Vuong, “Econometric Analysis of Collusive Behavior in a Soft-Drink Market,” Journal of Economics and Management Strategy, Summer 1992, pp. 277–311.
20Differentiating total profits P1 with respect to P1 (treating P2g as a constant), setting this expression equal to 0, and solving the resulting equation for P1 yields firm 1’s reaction function.
21Two excellent surveys are provided by Weiss, L. (ed.), Concentration and Price, Cambridge, MA, MIT Press, 1989, and Schmalensee, R., “Interindustry Studies of Structure and Performance,” in Schmalensee, R., and R. Willig (eds.), The Handbook of Industrial Organization, Amsterdam, Elsevier, 1989, pp. 951–1010.
22Bresnahan, T., and P. Reiss, “Entry and Competition in Concentrated Markets,” Journal of Political Economy, 99, 1991, pp. 997–1009.