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ECP 6701Competitive Strategies in Expanding Markets

Oligopoly

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Readings

BDSS Chapter 6 pages191-198 and 208-217

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Competition

If one firm’s strategic choice adversely affects the performance of another they are competitors

A firm may have competitors in several input markets and output markets at the same time

Competition can be either direct or indirect

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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 of the other because of a strategic reaction by a third firm

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Characteristics of Substitutes

Two products tend to be close substitutes when– They have similar performance characteristics– They have similar occasion for use and– They are sold in the same geographic area

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Performance Characteristics

Empirical Approaches to Competitor Identification– Cross price elasticity of demand – Pattern of price changes over time– Product characteristics – Products that belong to the same genre or the

same SIC need not be substitutes

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Occasion for Use

Products may share characteristics but may differ in the way they are used

Orange juice and cola are beverages but used in different occasions

Another example: Hiking shoes versus court shoes

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Geographic Area

Identical products in two different geographic markets will not be substitutes due to “transportation costs”

Bulky products like cement cannot be transported over long distances to benefit from geographic price difference

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Geographic Competitor Identification

When a firm sells in different geographical areas, it is important to be able identify the competitor in each area

Rather than rely on geographical demarcations, the firm should look at the flow of goods and services across geographic regions

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Two Step Approach to Identifying Competitors in the Area

First step is to find out where the customers come from (the catchment area)

The second step is to find out where the customers from the catchment area shop

With the technological innovations, some products like books and drugs are sold over the internet bringing in virtual competitors

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Market Structure

Markets are often described by the degree of concentration

Monopoly is one extreme with the highest concentration - one seller

Perfect competition is the other extreme with innumerable sellers

Oligopoly involves few sellers engaging in strategic competition

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Measuring Market Structure

A common measure of concentration is the N-firm concentration ratio - combined market share of the largest N firms

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

Entropy could be another measure of concentration

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Four Classes of Market Structure

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

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Oligopoly

Market has a small number of sellers 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

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Cournot Duopoly

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)

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Cournot Reaction Functions

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Cournot Equilibrium

If the two firms are identical to begin with, their outputs will be equal

Each firm expects its rival to choose the Cournot equilibrium output

If one of the firms is off the equilibrium, both firms will have to adjust their outputs

Equilibrium is the point where adjustments will not be needed

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Cournot Equilibrium

The output in Cournot equilibrium will be less than the output under perfect competition but greater than under joint profit maximizing collusion

As the number of firms increases, the output will drift towards perfect competition and prices and profits per firm will decline

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Bertrand Duopoly

In the Bertrand model, each firm selects its price and stands ready to sell whatever quantity is demanded at that price

Each firm takes the price set by its rival as a given and sets its own price to maximize its profits

In equilibrium, each firm correctly predicts its rivals price decision

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Bertrand Reaction Functions

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Bertrand Equilibrium

If the two firms are identical to begin with, they will be setting the same price as each other

The price will equal marginal cost (same as perfect competition) since otherwise each firm will have the incentive to undercut the other

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Cournot and Bertrand Compared

If the firms can adjust the output quickly, Bertrand type competition will ensue

If the output cannot be increased quickly (capacity decision is made ahead of actual production) Cournot competition is the result

In Bertrand competition two firms are sufficient to produce the same outcome as infinite number of firms

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Bertrand Competition with Differentiation

When the products of the rival firms are differentiated, the demand curves are different for each firm and so are the reaction functions

The equilibrium prices are different for each firm and they exceed the respective marginal costs

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Bertrand Competition with Differentiation

When products are differentiated, price cutting is not as effective a way to stealing business

At some point (prices still above marginal costs), reduced contribution margin from price cuts will not be offset by increased volume by customers switching