1. Economics of Strategy
Fifth Edition
Besanko, Dranove, Shanley, and Schaefer
Chapter 8
Competitors and Competition
Slides by: Richard Ponarul, California State University, Chico
Copyright  2010 John Wiley  Sons, Inc.

2. 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

3. 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

4. Identifying Competitors
DOJ Guideline: Merger with all the
competitors should lead to a small but
significant non-transitory increase in price
(SSNIP)
 Small: At east 5%
 Non-transitory: At least for one year

5. Identifying Competitors
 In practice any one who produces a
substitute product is a competitor
 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

6. Performance Characteristics
 Performance characteristics describe what
the product does to the customer
 Example from automobiles
 Seating capacity
 Curb appeal
 Power and handling
 Reliability

7. 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

8. 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

9. Empirical Approaches to Competitor Identification
 Cross price elasticity of demand
 Pattern of price changes over time
 Firms in the same Standard Industrial
Classification (SIC)

10. Cross Price Elasticity
Q y / Q y
 yx 
Px / Px
If ηyx is positive, consumers
purchase more of Y when the
price of X increases

11. Patterns in Price Changes
 Prices of close competitors tend to be highly
correlated
 Data on purchase patterns reveal how
individual consumers react when sellers
change their prices

12. Standard Industrial Classification (SIC)
 Products and services are identified by a
seven digit code
 Each digit represents a finer degree of
classification
 Products that belong to the same genre or
the same SIC need not be substitutes

13. 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

14. Identifying Competitors in the Area
 Step 1: Locate the catchment area. (where
the customers come from)
 Step 2: Find out where the residents of the
catchment area shop
 With some products like books and drugs
being sold over the internet identifying
geographic competition becomes more
difficult

15. 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

16. Measures of Market Structure
 The N-firm concentration ratio
(the combined market share of the largest N
firms)
 Herfindahl index (the sum of squared
market shares)
 When the relative size of the largest firms is
important Herfindahl is likely to be more
informative

17. Four Classes of Market Structure
Nature of Range of Intensity of Price
Competition Herfindahls Competition
Perfect Usually < 0.2 Fierce
Competition
Monopolistic Usually < 0.2 Depends on the degree
Competition of product differentiation
Oligopoly 0.2 to 0.6 Depends on inter-firm
rivalry
Monopoly > 0.6 Light unless there is
threat of entry

18. Perfect Competition
 Many sellers who sell a homogenous good
 Many well informed buyers
 Consumers can costlessly shop around
 Sellers can enter and exit costlessly
 Each firm faces infinitely elastic demand

19. Zero Profit Condition
 With perfect competition economic profits
go to zero
 When profits are maximized percentage
contribution margin or PCM = 1/ where 
is the elasticity of demand
 In perfect competition  is infinity and
hence PCM = 0

20. Conditions for Fierce Price Competition
Even if the ideal conditions are not present,
price competition can be fierce when two or
more of the following conditions are met.
 There are many sellers
 Customers perceive the product to be
homogenous
 There is excess capacity

21. Many Sellers
 Even when the industry is profitable, a low
cost producer may prefer to set a low price
 With many sellers, cartels and collusive
agreements harder to create and sustain
 Small players will be tempted to cheat and
small cheaters may go undetected

22. Homogeneous Products
 Three sources of increased revenue when
price is lowered
 Customers buying more
 New customers buying
 Customers switching from the competitors

23. Homogenous Products
 For firms that cut prices, customers
switching from a competitor are likely to
be the largest source of revenue gain
 Customers will be less loyal to the sellers
and sellers are more likely to compete on
price

24. Excess Capacity
 When a firm is operating below full capacity
it can price below average cost to cover the
variable cost
 If industry has excess capacity, prices fall
below average cost and some firms may
choose to exit
 If exit is not an option (capacity is industry
specific) excess capacity and losses will
persist for a while

25. Monopoly
 A monopolist faces little or no competition
in the output market
 Monopolist can act in an unconstrained way
in setting prices or quality
 If some fringe firms exist, their decisions do
not materially affect the monopolist’s profits

26. Monopoly
 A monopolist faces a downward sloping
demand curve
 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

27. Monopoly and Output
 The traditional anti-trust view is that limited
output and higher prices hurt the consumer.
 A competing (Demsetz) view is that
consumers may benefit even at monopoly
prices if the monopoly was the result of
product innovations and efficient
manufacturing.

28. Monopoly 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

29. Monopoly and Innovation
 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

30. Monopolistic Competition
 There are many sellers and they believe that
their actions will not materially affect their
competitors
 Each seller sells a differentiated product
 Unlike under perfect competition, in
monopolistic competition each firm’s
demand curve is downward sloping rather
than flat

31. Vertical and Horizontal Differentiation
 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

32. Geography and Horizontal Differentiation
 Grocery stores attract clientele based on
their location
 Consumers choose the store based on
“transportation costs”
 Transportation costs prevent switching for
small differences in price

33. Horizontal Differentiation
Figure 8.1: Sandwich Retailers in Linesville

34. Idiosyncratic Preferences
 Horizontal differentiation is possible with
idiosyncratic preferences
 Location and Taste are important sources of
idiosyncratic preferences
 Search costs discourage switching when
prices are raised

35. Search Costs and Differentiation
 Search cost: Cost of finding information
about alternatives
 Low cost sellers try lower the search costs
(Example: Advertising)
 Some markets have high search costs
(Example: Physicians)

36. Monopolistic Competition and Entry
 Since each firm’s demand curve is
downward sloping, the price will be set
above marginal cost
 If price exceeds average cost, the firm will
earn economic profit
 Existence of economic profits will attract
new entrants until each firm’s economic
profit is zero

37. Monopolistic Competition and Entry
 Even if entry does not lower prices (highly
differentiated products), new entrants will
take away market share from the
incumbents
 The drop in revenue caused by entry will
reduce the economic profit
 If there is price competition (products that
are not well differentiated) the erosion of
economic profit will be quicker

38. Monopolistic Competition and Entry
 Customer loyalty allows prices to exceed
marginal cost and encourages entry
 Entry considered excessive if fixed costs go
up due to entry without a reduction in prices
 If entry increases variety valued by
customers, then entry cannot be considered
excessive

39. 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

40. 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)

41. Cournot Duopoly: An Illustration
 Both firms have constant marginal cost of
$10
 Demand curve: P = 100 – Q1 – Q2
 Firm 1 chooses Q1 to maximize profits taking
Q2 as given
 Reaction function: Q1 = 45 – 0.5Q2
 Firm 2’s problem is a mirror image of Firm
1’s

42. Cournot Reaction Functions

43. 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

44. 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

45. 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

46. Bertrand Reaction Functions

47. 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

48. 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

49. 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

50. 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

51. Market Structure: Causes
 Theory would predict that the larger the
minimum efficient scale (MES) of
production the greater will be the
concentration.
 If entry is not easy concentration will be the
result
 Monopolistic competition would mean
easier entry and larger number of firms

52. Endogenous Sunk Costs
 Consumer goods markets seem to have a few
large firms and many small firms
 The number of large firms and the total
number of firms depend more on
advertising costs than production costs
(Sutton)
 Advertising costs are endogenous sunk costs

53. Endogenous Sunk Costs
 Early in the industry’s life cycle many small
firms compete
 The winners invest in their brand name
capital and grow large
 The smaller firms can try to match the
investment and build their own brands or
differentiate their products and seek niches

54. Price-Cost Margins & Concentration
 Theory would predict that price-cost
margins will be higher in industries with
greater concentration
 There could be other reasons for variation in
price-cost margins
 Regulation
 Accounting practices
 Concentration of buyers

55. Price-Cost Margins & Concentration
 It is important to control for these
extraneous factors to study the relation
between concentration and price-cost
margin
 Most studies focus on specific industries and
compare geographically distinct markets

56. Evidence on Concentration and Price
 For several industries, prices are found to be
higher in markets with higher concentration
 For locally provided services (doctors,
plumbers etc.) the “entry threshold” –
population needed to support a given
number of sellers – increases fourfold
between 1 and 2 sellers

57. Evidence on Concentration and Price
 En = entry threshold for n sellers
 For locally provided services E2 is about four
times E1
 E3 - E2 > E2 – E1
 E4 – E3 = E3 – E2
 Intensity of price competition reaches the
maximum with three sellers (Bresnahan and
Reiss)

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