Problem Set 2

5/28/2018 Problem Set 2

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Group 1

1913 Alexandre Ponte1921 Raquel Oliveira

1928 Jose Ollero Oliveira

Assistant Professor Sofia FrancoLisbon, 28th March 2014

Problem Set 2Strategy: Industry and Competition

NOVA School of Business and Economics Strategy I

Academic Year 2013/20141st Half of Second Semester


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PART I

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1.Antitrust laws benefit consumers by encouraging and protecting competition. These types of

laws prevent companies from acquiring too much market power and forbid the occurrence of

non-natural monopolies. In this way, companies do not have enough market power to

overcharge for their products and services and to prevent other firms from competing with them.

Ultimately, these laws intend to make companies competing on prices or on quality, with

continuous innovation, in order to maximize the consumers welfare.

2. The theory of predatory pricing refers to the situation when a company sets low prices in

order to eliminate the competition. This is an illegal strategy according with anti-trust agencies,

since it makes markets more vulnerable to a monopoly: in one hand, it creates barriers to entry

for potential entrants, and, on the other hand, it creates unethical production methods to

minimize costs. Furthermore, predatory pricing can be presented in two different ways: limit

price or predatory price. Limit price strategy is based on charging the highest price possible

which does not invite competition, preventing entry. It is possible, for example, exploiting

economies of scale advantage or investing earlier in capacity, which only allows the entrants to

break-even. Predatory price is when a firm decreases its price in order to drive rivals out of

business and/or scare off potential entrants, and then raises its price when its rivals exit the

market. In this case, the incumbent firm is willing to sacrifice its short-run profits, aiming to be

compensated by huge long-run profits and a stable and dominate position in the market

protected market power in the long- run.

In this way, it is clear that the theory of predatory pricing provides a useful contribution to

the theory of entry deterrence this theory refers to the situation when a incumbent firm in a

particular market takes a strategic action, by decreasing its price in order to discourage potential

entrants from entering into competition in that market. There are two general categories of

entry-deterring strategies: some strategies increase the expected entry cost for entrants, for

instance, through advertising expenditures; other strategies affect the entrants expectations of

the intensity of post-entry competition. In these last strategies, the incumbent firm is thinking

ahead and trying to anticipate the behavior of other firms, for instance, through investments inexcess capacity and by building a reputation for toughness through predatory pricing.

However, predatory pricing imply a good analysis of the market, since it is necessary to

understand not only the existence of barriers to entry, but also the future demand. Since the

incumbent is willing to sacrifice its short-run profits, aiming to be compensated by huge long-

run profits and a stable and dominate position in the market, the recovery is only possible if

there are strong barriers to entry, since is the only way to maintain the market power. Otherwise,

the new entrants are able to steal market power to the incumbent. Strategies of predatory

pricing can also work as a warning to the potential competitors, since there is a treat of using

this kind of policies to compete.


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3. Barriers to entry are anything that keeps new firms from entering in an industry in which

firms are able to earn economic profits. These can exist as a result of government intervention

(industry regulation, legislative limitations on new firms, special tax benefits to existing firms,

etc.), or they can occur naturally within the business world. Some naturally occurring barriers to

entry could be a strong brand identity, strong customer loyalty or high customer switching

costs.1Thus, there are infinite barriers but they can be classified into two general categories of

barriers to entry: the natural barriers to entry and the strategic or legal barriers to entry.

Strategic or legal barriers to entry are created by firms choicesin order to avoid competition

within the same market the possibility of entry affects the payoffs of incumbents, while

strategies by incumbents are meant to reduce entrants payoffs (if entry occurs).Examples of

such strategies include exclusive or superior access by an incumbent undertaking to particular

necessary inputs such as patents; copyrights; exclusive contracts with input suppliers; etc. So,

these are controlled by intervenients in the market. Entry barriers arising from predatory

behaviour are more examples, such as predatory pricing, expansion of capacity, excessive

advertising, or the introduction of new products for strategic purposes. Entry impediments give

incumbents the opportunity to enjoy monopoly benefits for a certain period of time e.g., the

time of attaining a licensebut are not entry barriers in the strict sense; they only influence how

much time incumbents may exercise market power before entry occurs.

On the other hand, structural or natural entry barriers are only part of market economy and

have not the purpose to distort or prevent competition.2 So, these are not controlled by the

intervenients. However, they can certainly have impact and effect on the market and on the

ability of firms to compete on the market natural barriers to entry give rise to natural

monopoly. Natural barriers include economies of scales, network effects higher usage of

certain products makes them more valuable , ownership of a key input, natural product

differentiation, and an absolute cost advantage held by an incumbent over an entrant. Legal

barriers (government intervention) or geographic barriers (difficulties for foreign firms to play

in domestic markets) are more examples of natural barriers to entry. To conclude, there are

barriers to entry over which neither incumbents nor the entrants have direct control thestructural barriers to entry. Economies of scales, for example, act as a barrier to entry if the

Minimum Efficient Scale (MES) is large to the total size of the market; the firm is operating in

the lowest point on the long-run average cost (LRAC) function, allowing them to grow in large

size, control the supplies and guarantee that other firms will not be able to compete. So, either

the entrant accepts the risk associated with large-scale entry in order to avoid penalty, or it

enters at a smaller scale and takes the average cost penalty.3

1 http://www.investopedia.com/terms/b/barrierstoentry.asp2 http://www.diva-portal.org/smash/get/diva2:19800/FULLTEXT01.pdf3Lipczynski, J.; Wilson, J.; Goddard, J.; Goddard, J.; Industrial Organization: Competition, Strategy, Policy, 2ndEdition, FT Press.


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4. Although concentration ratios are useful indicators of possible market power, they are not

perfect measures of market power, since it is almost impossible to gather the necessary

information on prices and mainly costs. High concentration ratios do not prove firms are using

market power to charge high prices or to practice anticompetitive behavior.

Market power is the ability of a firm to profitably raise the market price of a good or service

over marginal cost.4A firm with high market power has the ability to individually affect either

the total output or the prevailing price in the market. Price makers face a downward-

sloping demand curve, such that price increases lead to a lower quantity demanded. The

decrease in supply as a result of the exercise of market power creates an economic deadweight

loss which is often viewed as socially undesirable. But, industries can also be profitable or have

high concentration levels because they have successfully met the consumersneeds and wants,

and then, being large is not prejudicial. So, it is important to evaluate whether or not firms on

oligopoly markets are using market power to charge high prices and avoid competition.

An analysis between prices and concentration levels is mostly useful when there's data

available for several geographic areas with different concentration levels and the alleged

problem arises in only one (or a few) of these areas. As a result, if there isn't a correlation

between price and a wide range of concentration in a narrow market, then higher prices isnt

related with the increase in concentration. By contrast, if price is steadily higher where

concentration is higher, maybe firms are beneficiating of their market power to set higher prices.

Another approach is to compare profits of small and bigger firms. If the bigger companies in

a market with similar profit rates of the smaller ones, they are not taking advantage of

economies of scale; it suggests the market power is not being used to leverage prices.

Otherwise, it can be that small firms are not willing to engage in price wars, hence, they charge

a similar price as the larger firms.

A comparison of profit' rates among an industry and other industries with less concentration

ratios is also a useful way to study this issue. However, alongside with this consideration, it is

essential to examine where come from those profits. For example, low costs of production due

to: economies of scales; better negotiation power with suppliers; lower margins earned bysuppliers; product differentiation; or low competition levels.

Finally, if there is high concentration overtime in a market, and it does not become less

concentrated over the following years, it is probable that firms in that market may be colluding

to avoid the entrance of new competitors, especially if considering a rapid growing and

attractive market. Thus, in markets that are highly concentrated, the anti-trust entities should

closely control the actions of the firms with higher market power, to ensure they are not using it

unlawfully and in a way that is anticompetitive and adverse for consumers.

4 Perloff, J: Microeconomics Theory & Applications with Calculus page 369. Pearson 2008.


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PART II

4

1. In a Stackelberg game, that is a sequential decision game where a firm (the leader) will move

first and the other firm (the follower) will move after there can be advantages to moving second.

Assuming homogenous firms and homogenous products a firm that moves first will gain an

advantage if competing in quantities because as a leader it gets to set its equilibrium quantity

and assuming this commitment is credible forces the follower to accept this as the equilibrium

of the market because deviations will hurt the follower firm, naturally the leader will set an

equilibrium with the highest possible profits for itself leaving the follower to pick up the scraps,

the decisions of the firms are strategic substitutes, that is if one firm increases quantity it forces

the other firm to respond by decreasing quantity.

However should firms compete in prices under the same assumptions as before it is unlikely

that the first mover will gain an advantage over the follower, the opposite is in fact more likely.

Under Stackelberg price competition the leader will choose first and assuming that he chooses a

price that is greater than its marginal costs (ie: that there is room to decrease the price) then the

follower observing the action of the leader will naturally respond by setting its own price lower

and gaining the upper hand in the market, the follower experiences second-mover advantage.

In equilibrium the price of the good must be set equal to marginal cost by both firms because

setting it higher than that will give the other firm the advantage and lower will bankrupt the

company, this result is identical to Bertrand competition.

Should products not be identical, but only broadly speaking similar then even under price

competition there can be significant advantages to moving first depending on how much it costs

the consumer to switch to a different (cheaper but still similar) alternative, a firm that enters the

market after the leader will have to give consumers a very good deal as otherwise the switching

costs will not compensate the move to the lower priced alternative.

Firms offering similar but not identical products can also gain first mover advantages through

effects outside of their control, for example a first mover in an online business can capture

network externalities that encourage more and more people to adopt their service and

discourage users from moving to different services.

If the firms themselves are not identical then there are other factors (unique to the firms)outside the games mechanisms themselvesthat can give the leading firm the upper hand, for

example by virtue of being first to the market firms can optimize production techniques that

they can keep secret giving them a lower cost curve than their competitors so that even under

price competition they will have the upper hand.

However, being the first to develop technology or production process can be a double edged

sword because if a follower firm can gain access to that technology then they can effectively

free ride on the first movers investments giving them the advantage.


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PART II

5

2. In a competitive market the incentive to innovate is immense, a firm that successfully

innovates gains an advantage over the rest of the market and should its competitors not be able

to keep up it can leverage that advantage to gain market share and profit.

The profit and market share a firm can gain from outdoing the competition and the

disadvantages it can have from being outdone provide the primary incentive to innovate in a

competitive market. The consumer will obviously benefit as the innovating firm will lower

prices to try and gain market share and force all the other firms to do try and do the same.

It is interesting to note that in a perfectly competitive market with perfect knowledge

diffusion there is no reward for innovation as the innovating firm will see its innovation

immediately copied by all firms in the market and will thus never be rewarded for innovating,

this is one of the justifications for a patent system.

In the case of a monopolist firm things are not so clear, the firm faces no competition and so

the primary incentive to innovate in a competitive market is gone, however the firm still has a

profit motive as innovations that reduce costs will still lead to increased revenues for the

company and facing a traditionally convex demand curve the company will still lower costs for

consumers, in that sense innovation by a monopoly will still benefit consumers.

However, the hypothesis that a monopoly will innovate is suspicious, after all innovation

requires risk taking, it demands that the company incur costs today with the perspective of in the

future making enough profits from their innovation to recoup those costs, it does not know at

the moment it incurs costs if their investment will ever pay off.

Faced with risks a monopoly may simply choose not to invest in innovation, the incentive of

future profits without the threat of competitors overtaking it may not be enough to make a

monopolist invest in cost cutting technology due to its natural risk aversion.

P

P1

P2

Q1 Q2Q

MC1 = AC1

MC2 = AC2

CS1

CS2

D


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PART II

6

3.Selling a product at below cost can be a strong indicator of predatory pricing, a firm that sells

at below industry cost and has enough capital to absorb the losses that this practice entails can

effectively take the entire market forcing others to leave or to go bankrupt if they try to keep up

it is therefore appropriate that firms who engage in below cost pricing are put under scrutiny. In

order for a predatory pricing strategy to succeed the firms that are expelled from the market

must face significant barriers to re-entry when the predator decides to raise prices to reap the

rewards of its strategy otherwise the predator will simply end up in a similar situation where it

began and the losses it took from its predatory pricing will not be offset.

However, a firm may also have legitimate and not anti-competitive reasons to price goods at

below cost and in some industries it has effectively become the norm to practice below cost

pricing under re-occurring circumstances for example the clothing industry which has re-

occurring sales periods where prices are cut to the bone in order to liquidate inventory it

accumulated in a given season. These kind of huge sales are also part of a legitimate business

strategy where a company will put certain goods on sale selling them potentially below cost in

order to entice customers to visit its store this is seen in traditional industries such as

supermarkets but also in new online stores such as amazon.com or the Steam games platform.

A business may also choose to sell at below costs in order to liquidate its inventory before or

in a desperate move to prevent closure; this practice is very often seen during recessions.


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PART III

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1. Firms can construct excess capacity in a noncooperative strategic way or not. Markets with

excess productive capacity (with more than one incumbent) may involve strong price

competition and so will tend to present an unattractive panorama to potential entrants. So, the

investment in capacity can be an entry-deterring strategybut will not provoke antitrust suspicion,

since it may serve as a credible commitment to expand output and drop price.Excess capacity can

deter entry by forming expectations on the part of potential entrants that dominant firms are

capable of responding aggressively to threats.

We concentrate on the duopoly case to allow for a graphical representation. In this situation,

firm 1 is the incumbent firm (I), and firm 2 is the potential entrant (E). Because the decision can

be made sequentially, it may be in the best interests of the incumbent firm to make a strategic

commitment (moves first in a credible manner) that acts as a strategic entry barrier.

Furthermore, there will be two stages in this game: in the first stage, the only player in the

market is the incumbent firm and can choose a particular amount of capacity ( ); in thesecond stage, the entrant makes its entry decision. As the incumbent can take advantages ofbeing in the market, it has the first move advantage, and so we assume that each one extra unit

invested in capital () leads to one extra unit of production. On the other hand, the entrant needsto invest in capacity to enter in the market; it pays a fixed cost.

Relation between MC and capacity:

In case of deciding to enter in the market, the new entrant will have to invest in capacity and

its marginal costs will at least equate those of firm 1. As we can see from the graph the marginal

costs curve for firm 1 is kinked at . Firms have the same production costs they have fixedcosts of production (1 unit of laborWand 1 unit of capacityR). In order to prevent firm 2

from entering into the market, the incumbent firm has to invest in capacity in a way that firm 2

profits will be equal to zero; this means firm 1 has to choose its initial capacity investment level

so that best response of firm 2 will be its break-even point. In a more drastic way, firm 1 has to

choose its initial capacity investment level so that best response of firm 2 will be the shutdown

point the potential entrant will be quick out of the market while the incumbent keeps its

monopoly.

E

E

00


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As both firms have the same cost structure, so they

have constant and equal marginal costs. Besides, since

firms choose any quantity to produce, and they make

their quantity choices simultaneously while playing the

game, they are competing la Cournot.

In the graph below, the best response function of the incumbent is (W) until , andfurther that point, the best response function of the incumbent is (W+R). Thus, at point,the best response function is the link of the previous functions. These are the reasons why the

reaction function of the incumbent, which is represented in light green, has different slopes. On

the other hand, the potential entrants reaction function(W+R) is the function in darkblue. Since both firms are competing la Cournot, their optimal quantities are strategicsubstitutes: if , then will necessarily decrease, and so it will be lower than 2. For thisreason, if the entrant decides to continue operating in this market, its profit will decrease as

well, and, in fact, the entrant firm will earn negative profits. By contrast, if , it will bepossible for firm 2 to produce more than 2. As result, the entrant firm will earn positive profitsif one decides to continue operating in the market.

So, the equilibrium is achieved by the intersection of both reaction functions. At Cournot

Equilibrium point, on the second stage, equals , and the incumbent firm will operate at fullcapacity. The incumbent was not able to quick out the entrant. As consequence, the best the

entrant can do is to break-even ( ), and 2is the exact amount that break even. Therefore,To conclude, the potential entrant doesnt have incentive to enter in this market, since its

entrance is blocked when equals . Thats why the potential entrant will decide to notcompete in the market.

PSD

1

12

Cournot

Equilibrium

with

1

2

2


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2.First, it is important to define what a horizontal merger is. It is a merger between firms

that provide similar products or services. It allows the surviving firm to control a greater share

of the market and, it is hoped, gain economies of scale5.

Therefore, horizontal mergers can result in anti-trust problems in the marketplace by

reducing competition. The antitrust agencies typically have to investigate whether potential

positive merger effects are likely compensated by potential anticompetitive effects, such as the

increase of prices, caused by the merger.

Nevertheless, if the intention of the merger is to decrease the cost structure and get some cost

savings, and if that goal is achieved in reality, firms can actually lower the price in that market.

The fact that the number of firms has fallen increases market power and puts upward

pressure on price, but if the cost savings were high enough, the firms may actually lower price

in the market. Even if the price does rise, total welfare may still improve if there are cost

advantages. If the merger makes the firms much more efficient and thus yields greater profits

without increasing the price to consumers by much, total welfare may improve.

In sum, just because a horizontal merger reduces the number of firms in an industry, it is not

necessarily true that the price will be raised and, consequently, hurting total welfare hurting total

welfaretotal welfare will not be harmed as long as area C > area B.

The tradeoff that arises when a merger simultaneously produces cost savings and higher

prices due to greater market power:

5 http://www.ask.com/question/what-is-a-horizontal-merger

P

P1

P2

Q1Q2Q

A BMC1

MC2

D

C

A:Increase in the Producer Surplus

B:DWL

C: Transfers from Consumers to Producers


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3.In 2013, Apple faced accusations of colluding with major publishing houses to fix eBooks

prices that they sell on the iBookstore. The company refused such allegations and even stated

that they provided a valuable service to consumers, by fighting Amazons eBook monopoly.

The court Judge had then to decide if the companies had been enduring conspiring to fix prices

prior to the iPad launch in 2010.

In oligopolistic markets, such as the eBooks, there is a strong incentive for companies to

collude and to become better off than if they competed regularly. They fix the price above the

competitive market equilibrium to steal surplus from the consumers (and some also becomes

dead weight loss).

The following graph illustrates the incentives that firms have to collude.

By colluding, these firms can operate together as a monopoly, achieving the maximum

welfare and higher profits than they would get in a free competitive market. Thats why they

engage in this sort of behavior.

However, this brings undesired effects for consumers, and that is why market regulators

intervene, to protect the consumers best interest, which was what the U.S. government was

doing in this case.

Firm 1 Reaction

Firm 2 Reaction Function


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PART IV

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a) We are facing a market whose inverse demand is given by and two firmsoperate in this market. Both firms have constant marginal costs of 40 and, since firms choose

any quantity to produce, and they make their quantity choices simultaneously, they are

competing la Cournot. In order to find the Nash equilibrium of this game, we had plotted the

FOC of each firm. From the FOC of firm 1, we obtained the output that maximizes the profits of

firm 1 as a function of the output of firm 2the best response of firm 1:

As both firms are identical and have the same cost structure, they will have the same reaction

function. So,

Hence, the equilibrium is achieved by the intersection of both

reaction functions:

The Nash equilibrium is characterized by the quantities that each firm had produced 60and by the industry price = 160.Profits are given respectively by:

b) In order to find the monopoly output, that maximizes the total industry profit, the marginal

revenue equals the marginal cost (MR=MC). So, .Since both firms are competing la Cournot, their optimal quantities are strategic

substitutes: if increases, then decreases as well as , and vice-versa. Therefore, if eachfirm produces one half the monopoly output ( 45), the best-response wouldbe

. This makes sense because their reaction functions have negative

slope. Thus, a firm reduces its output to 45, the other will increase its initial output to 67.5.

However, knowing that firm 2 produces 67.5, the best-response of firm 1 is not to produce

45 but to produce 56.25 . Hence, half of the monopoly output is not a Nashequilibrium outcome. This happens because firms will compete until the Nash equilibrium is

achieved.

c) In the new situation, firms have now different cost structures: firm 1 has a cost advantage (its

unit cost is 25) and firm 2 still has a unit cost of 40. Again, in order to find new outcome, wehad plotted the FOC of each firm. From the FOC of firm 1, we obtained the output that


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maximizes the profits of firm 1 as a function of the output of firm 2the best response of firm 1

and the output that maximizes the profits of firm 2 as a function of the output of firm 1 the

best response of firm 2:

Hence, the equilibrium is achieved by the intersection of both reaction functions:

Firms will have now different profits, individual outputs and the industry price will differ

from a). The Nash equilibrium is characterized by the quantities that each firm had produced and by the industry price = 155.Profits are given respectively by:

8450 6612.5

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Problem Set 2

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