Economics of StrategyCompetitors and Competition

Kelompok 2

Punya RASA Punya Selera

Robi-Akhmad-Sahnu-Arya

ROAD MAP

Market Structur

e

Identify Competito

rs

Define the Market

SSNIP

Price Correlatio

n

Cross Price

Elasticity of

Demand

SIC Codes

SSNIP

Own Price Elasticity

Measuring

Herfindahl Index

N-firm Concentrati

on Ratio

Monopoly

Oligopoly

Monopolistic

Competition

Perfect Competitio

n

Market structure affects market competition

Identify Competitors - SSNIP• Simple conceptual guideline

followed by anti-trust authorities: merger with all the competitors should lead to a small but significant nontransitory increase in price (SNIP criterion)

• Small, but significant = 5% for US DoJ

5 to 10% for EU

Identify Competitors – Price Correlation• Two firms can be said to compete if a price

increase by one firm drives its customers to the other firm

• Two products X and Y are subtitutes if, when the price of X increases and the price of Y stays same, purchases of X go down and purchase of Y go up.

• Two products tend to be close substitutes when these 3 criteria are jointly satisfied:– They have similar performance characteristics– They have similar occasion for use and– They are sold in the same geographic area

Identify Competitors – Cross Price Elasticity of Demand • Two firms can be said to compete if a price

increase by one firm drives its customers to the other firm

• Two products X and Y are subtitutes if, when the price of X increases and the price of Y stays same, purchases of X go down and purchase of Y go up.

• Two products tend to be close substitutes when these 3 criteria are jointly satisfied:– They have similar performance characteristics– They have similar occasion for use and– They are sold in the same geographic area

Identify Competitors – Standard Industrial Classification (SIC) Codes• SIC Codes identify products and services

by a seven-digit identifier, with each digit representing a finer degree of classification.

• Example : Code 35 => Industrial and Commercial Machinery and computer equipmentCode 3523 => Farm machinery and computer eqipmentCode 3534 => Elevators and moving stairways

Market Definition

• Start with a “thought experiment”– suppose all firms in the supposed

market could coordinate their prices– would they choose to raise prices by at

least 5%?• if yes then there are few “outside” competitors• the market is well defined

• Related to own-price elasticity of demandŋx = -

% change in quantity demanded of x

% change in price of x

If ŋx is “small” then sellersface few constraints on

their ability to raise prices.

Measuring Market Structure• A common measure of concentration is the

N-firm concentration ratio - combined market share of the largest N firms CR4 = Si Si where Si is firm’s i market share and

i= 1, …4

• Herfindahl index is another which measures concentration as the sum of squared market shares

H = Si Si2 where

i = 1,…….n (n is total number of firms in the market)Structure Herfindahl Index Intensity of Price Competition

Perfect Competition Usually < 0.2 Fierce Monopolistic Competition Usually < 0.2 Depends on the degree of product

differentiation Oligopoly 0.2 to 0.6 Depends on inter-firm rivalry Monopoly > 0.6 Light unless there is threat of entry

Market Structure

Perfect Competition

• Many sellers who sell a homogenous product and many well informed buyers

• Consumers can costlessly shop around and sellers can enter and exit costlessly

• Each firm faces infinitely elastic demand

Monopoly

• A monopolist faces little or no competition in the product market

• Monopolist can act in an unconstrained way in setting prices

• If some fringe firms exist, their decisions do not materially affect the monopolist’s profits

Market StructurePerfect Competition

• With perfect competition economic profits go to zero

• Percentage contribution margin PCM equals (P - MC)/P where P and MC are price and marginal cost respectively

• When profits are maximized PCM = 1/ where is the elasticity of demand

• Since is infinity, PCM = 0

Market StructureMonopoly and Output

• A monopolist sets the price so that marginal revenue equals marginal cost

• Thus the monopolist’s price is above the marginal cost and its output below the competitive level

• The traditional anti-trust view is that limited output and higher prices hurt the consumer

Market StructureMonopoly and Innovation

• A monopolist often succeeds in becoming one by either producing more efficiently than others in the industry or meeting the consumers’ needs better than others

• Hence, consumers may be net beneficiaries in situations where a firm succeeds in becoming a monopolist

• Monopolists are more likely to be innovative (than firms facing perfect competition) since they can capture some of the benefits of successful innovation

• Since consumers also benefit from these innovations, they are hurt in the long run if the monopolist’s profits are restricted

Market Structure

Characteristics : Numerous buyers and sellers Differentiated products Free entry and exit in the long run

An important determinant of a firm’s demand is customer switching

Switching is less likely when Customer preferences are idiosyncratic Customers are not well informed about

alternative sources of supply Customers face high transportation costs

Monopolistic Competition

Market Structure

Differentiation Classification 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 (Spatial Differentiation)

Monopolistic Competition

Market StructureMonopolistic Competition

Profit Maximization : Produce output where MR = MC. Charge the price on the demand curve that

corresponds to that quantity.

Market StructureOligopoly Competition

Characteristics : Market has a small number of sellers The products firms offer can be either

differentiated or homogeneous Pricing and output decisions by each firm

affects the price and output in the industry Oligopoly models (Cournot, Bertrand)

focus on how firms react to each other’s moves

Market StructureOligopoly Competition

The effect of a price reduction on the quantity demanded of your product depends upon whether your rivals respond by cutting their prices too!

The effect of a price increase on the quantity demanded of your product depends upon whether your rivals respond by raising their prices too!

Strategic interdependence: You aren’t in complete control of your own destiny!

Market StructureOligopoly Competition – Cournot Model

In the Cournot model each of the two firms pick the quantities Q1 and Q2 to be produced

Each firm takes the other firm’s output as given and chooses the output that maximizes its profits

The price that emerges clears the market (demand = supply)

Market StructureOligopoly Competition – Bertrand Model

Characteristics : Few firms that sell to many consumers. Firms produce identical products at constant

marginal cost. Each firm selects its price and stands ready to sell

whatever quantity is demanded at that price Each firm independently sets its price in order to

maximize profits. In equilibrium, each firm correctly predicts its rivals

price decision

Market StructurePrice-Cost Margins and Concentration

Theory would predict that price-cost margins will be higher in industries with greater concentration (fewer sellers)

There could be other reasons for inter-industry variation in price-cost margins (regulation, accounting practices, concentration of buyers and so on)

For several industries, prices are found to be higher in markets with fewer sellers

The concentration and profitability have not been shown to have a strong relationship

Possible explanations : Differences in accounting practices may hide the

differences in profitability When the number of sellers is small it may be due to

inherently unprofitable nature of the business

Market StructurePrice-Cost Margins and Concentration

Theory would predict that price-cost margins will be higher in industries with greater concentration (fewer sellers)

There could be other reasons for inter-industry variation in price-cost margins (regulation, accounting practices, concentration of buyers and so on)

For several industries, prices are found to be higher in markets with fewer sellers

The concentration and profitability have not been shown to have a strong relationship

Possible explanations : Differences in accounting practices may hide the

differences in profitability When the number of sellers is small it may be due to

inherently unprofitable nature of the business

Industry analysis facilitates– assessment of industry and firm

performance– identification of factors that affect

performance– determination of the effect of changes in

the business environment on performance and

– identification of opportunities and threats (SWOT analysis)

Industry Analysis

Michael Porter’s Five-Forces framework identifies the economic forces that affect industry profits

The five forces areInternal rivalryEntrySubstitutes and complementsSupplier powerBuyer power

The Five-Forces Framework

The Five-Forces Framework

Internal Rivalry

• Internal rivalry is the competition for market share among the firms in the industry

• Competition could be on price or some non-price dimension

• Blue Ocean Vs Red Ocean

Sample non price Competition

Internal Rivalry

Price competition heats up when– There are many sellers– Some firms have cost advantage over

others– There is excess capacity in the industry– Products are undifferentiated and switching

costs are low– Prices and sale terms are easily observable– Industry demand is elastic

Sample Price Competition

Entry• Entry hurts the incumbents by– By cutting into the incumbents’ market share and– By intensifying internal rivalry and leads to a

decline in price cost margin

• Factors that Affect the Threat of Entry– Minimum efficient scale relative to the size of the

market – Government policies that favor the incumbents– Brand loyalty of consumers and value placed by

consumers on reputation– Entrants’ access to critical resources such as

raw material, technical know how and distribution network

Substitutes and Complements

 

Substitutes Vs Complements ???

Supplier Power Supplier has indirect power if upstream market is competitive.

They sell to the highest bidder.

The price supplier charge depends on the supply and demand in the upstream market (i.e fuel supplier)

Supplier has direct power, which could erode industry profit, if

– the upstream industry is concentrated or

– the customers are locked into the relationship with suppliers due to relationship specific assets

Buyer Power Buyer power is analogous to supplier power

The ability of individual customers to negotiate purchase prices that extracts profit from sellers

Buyers have indirect power in competitive markets

Buyer concentration or relationship specific assets investment can lead to direct power (i.e Fertilizer Industry)

Buyer power relative to upstream is analogous to supplier power relative to downstream

Supplier PowerThe factors that determine supplier power are

Competitiveness of the input market

The relative concentration the industry

Relative concentration of upstream and downstream firms

Purchase volume of downstream firms Availability of substitute inputs Extent of relationship specific investments Threat of forward integration by suppliers Suppliers’ ability to price discriminate

Strategies for Coping with the Five Forces A five-forces analysis identifies the threats to the profits off all

firms in an industry

To outperform its rivals firms can be able to :

develop a cost advantage or

a differentiation advantage

Firms can seek an industry segment where the five forces are less severe

Firms can try to change the five forces

Facilitating strategies to reduce internal rivalries

Moves that increase switching costs for the customers

Pursuing entry deterring strategies

Tapered integration to reduce buyer/supplier power

Strategies for Coping with the Five Forces

Limitation Michael Porter’s five-forces Framework

It pays little attention to factors that might affect demand. It accounts for the availability and prices of substitute and complementary products, it ignores changes in consumer income, tastes, and firms’ strategies for boosting demand.

It focuses on a whole industry rather than on that industry’s individual firms.

The framework does not explicitly account for the role of the government.

The five-forces analysis is qualitative. Thus, it is especially useful for assessing trends.

Brandenberger and Nalebuff’s Coopetition

• They describe the firm’s value net, which includes suppliers, distributors, competitors and complementors

• Whereas Porter describes how suppliers, distributors, competitors and complementors might destroy a firm’s profits, Brandenberger and Nalebuff’s key insight is that these firms often enhance firm profits.

The Value Net ConceptThe value net consists of

SuppliersCustomersCompetitors andComplementors (producers of

complementary goods and services)The value net complements the five forces

approach by considering opportunities posed by each force.

Five Forces and Value NetThe Five-Forces Framework tends to view

other firms - competitors, suppliers or buyers - as threats to profitability

In the value net model (Competition) interactions between firms can be positive or negative

Cooperative Interactions among Firms

Setting industry standards that facilitate industry growth

Lobbying for regulation or legislation that favors the industry

Cooperation with buyers/suppliers to improve product quality to improve productive efficiency to improve inventory management

“Competition is always a fantastic thing, and the

computer industry is intensely competitive. Whether it's Google or Apple or free software,

we've got some fantastic competitors and it keeps us on our

toes”

~Bill Gates~