Market Structure Market Structure and Strategic and Strategic CompetitionCompetition

Chapter 6Chapter 6

Key ConceptsKey Concepts

Defining the MarketDefining the Market

Ideal market definition should take into account the Ideal market definition should take into account the possibilities for substitutionpossibilities for substitution

If substitution across goods/services is easy, these If substitution across goods/services is easy, these goods/services should be considered one marketgoods/services should be considered one market Production dimensionProduction dimension Geographical dimensionGeographical dimension

Substitution versus new entrySubstitution versus new entry

Substitution on the production side should be included only Substitution on the production side should be included only if the existing capacity can be shifted in the short run to if the existing capacity can be shifted in the short run to produce those substitutesproduce those substitutes

Concentration RatioConcentration Ratio A fundamental problem with concentration ratios is they only A fundamental problem with concentration ratios is they only

discuss one point in the distribution of firms’ market sharesdiscuss one point in the distribution of firms’ market shares

Depending on the number of firms, concentration ratios can Depending on the number of firms, concentration ratios can be contradictorybe contradictory

Concentration: an Concentration: an ExampleExample

Herfindahl and Hirschman IndexHerfindahl and Hirschman Index

HHI is defined as the HHI is defined as the sum of the squared market shares of all firmssum of the squared market shares of all firms i in the industryn the industry

In that way HHI includes information on all firms in the industryIn that way HHI includes information on all firms in the industry

HHI can be thought of as the average slope of the concentration curvHHI can be thought of as the average slope of the concentration curve in the industry (steeper slopee in the industry (steeper slopemore concentration)more concentration)

HHI maximum is attained at 10000 (a single producer)HHI maximum is attained at 10000 (a single producer)

Regulation authorities use the threshold of 1000 as criticalRegulation authorities use the threshold of 1000 as critical

Concentration Curves: an Concentration Curves: an ExampleExample

Concentration of Selected Concentration of Selected IndustriesIndustries

HHI and PolicyHHI and Policy

Empirical evidence has demonstrated Empirical evidence has demonstrated the positive association of high HHI the positive association of high HHI values with high price-cost marginsvalues with high price-cost margins

Why do we have this positive Why do we have this positive relationship?relationship? Collusion hypothesisCollusion hypothesis Differential efficiency hypothesisDifferential efficiency hypothesis

Minimum Efficient ScaleMinimum Efficient Scale

To achieve low unit costs, some firms need to engage in To achieve low unit costs, some firms need to engage in large-scale productionlarge-scale production

When efficient production scale (reached in the long run at When efficient production scale (reached in the long run at the minimum of the average cost curve) is comparable to the minimum of the average cost curve) is comparable to the market, there is only room for a few large firms in that the market, there is only room for a few large firms in that industryindustry

Specialization is usually cited as a major reason for firms to Specialization is usually cited as a major reason for firms to gain from large-scale productiongain from large-scale production

However, empirical research has found most firms operate However, empirical research has found most firms operate at larger scales compared to the minimum efficient scaleat larger scales compared to the minimum efficient scale

Is there any room for collusion here?Is there any room for collusion here?

Minimum Efficient ScaleMinimum Efficient Scale

Entry ConditionsEntry Conditions

The number of active firms is The number of active firms is determined by the ease of entrydetermined by the ease of entry Cost factorCost factor Economies of scaleEconomies of scale

Entry conditions determine the Entry conditions determine the extent of potential competitionextent of potential competition

Free EntryFree Entry

Remember the present value of an infinite stream of Remember the present value of an infinite stream of benefits of equal nominal size for interest rate r is equal to benefits of equal nominal size for interest rate r is equal to the reciprocal of r (B/r, the taxi driver license example)the reciprocal of r (B/r, the taxi driver license example)

Suppose a firm’s profit in each year depends on the number Suppose a firm’s profit in each year depends on the number of firms in a decreasing fashionof firms in a decreasing fashion

We can then identify the amount of firms in the industry We can then identify the amount of firms in the industry given the entry costsgiven the entry costs

When entry costs increase, the equilibrium amount of firms When entry costs increase, the equilibrium amount of firms under free entry decreasesunder free entry decreases

Effect of the Cost of Entry Effect of the Cost of Entry on Equilibrium Number of on Equilibrium Number of

FirmsFirms

Barriers to EntryBarriers to Entry

Barriers to entry are difficult to defineBarriers to entry are difficult to define Are patents barriers to entry?Are patents barriers to entry? Will welfare increase if patent rights will be waived?Will welfare increase if patent rights will be waived?

One definition of an entry barrier says: a barrier to entry One definition of an entry barrier says: a barrier to entry may be defined as a cost of producing which must be borne may be defined as a cost of producing which must be borne by firms seeking to enter an industry but is not borne by by firms seeking to enter an industry but is not borne by firms already in the industryfirms already in the industry

The socially oriented definition says: socially undesirable The socially oriented definition says: socially undesirable limitations to entry of resources which are due to protection limitations to entry of resources which are due to protection of resource owners already in the marketof resource owners already in the market

Scale Economies as Barriers Scale Economies as Barriers to Entryto Entry

Entry may result in too much output that can only Entry may result in too much output that can only be sold at a price that is below average costbe sold at a price that is below average cost

Even if the new entrant produces a lower amount Even if the new entrant produces a lower amount compared to the efficient one, the unit costs will be compared to the efficient one, the unit costs will be still too high for it making entry unprofitable in still too high for it making entry unprofitable in either caseeither case

Undercutting the incumbent may not work since Undercutting the incumbent may not work since consumers are normally loyal to the existing consumers are normally loyal to the existing brands and advertising increases the entrant’s brands and advertising increases the entrant’s costs againcosts again

Scale Economies as Barrier to Scale Economies as Barrier to EntryEntry

Contestability and Sunk Contestability and Sunk CostsCosts

A market is A market is perfectly contestable perfectly contestable if three conditions are metif three conditions are met Potential entrants have no technological disadvantage with Potential entrants have no technological disadvantage with

respect to the incumbentsrespect to the incumbents Zero sunk costs: all costs associated with entry are fully Zero sunk costs: all costs associated with entry are fully

recoverablerecoverable The entry lag is less than the price adjustment lag for The entry lag is less than the price adjustment lag for

incumbentsincumbents

If market is If market is perfectly contestable,perfectly contestable, the equilibrium should the equilibrium should entail a socially optimal outcomeentail a socially optimal outcome

Hit-and-run entry will result in the incumbent firm pricing at Hit-and-run entry will result in the incumbent firm pricing at average costaverage cost

In this way sunk costs are barriers to entryIn this way sunk costs are barriers to entry

Dominant Firm TheoryDominant Firm Theory

There is one big firm and a large number of small price-taking firmsThere is one big firm and a large number of small price-taking firms

The dominant firm first selects the price which the fringe takes as givenThe dominant firm first selects the price which the fringe takes as given

The dominant firm’s residual demand is the difference between market The dominant firm’s residual demand is the difference between market demand and the fringe’s supplydemand and the fringe’s supply

At price P0, the fringe produces nothing so the dominant firm has all the At price P0, the fringe produces nothing so the dominant firm has all the marketmarket

The dominant firm prices at P* where its marginal revenue is equal to The dominant firm prices at P* where its marginal revenue is equal to marginal costmarginal cost

The dominant firm’s residual demand is flatter than the market demand The dominant firm’s residual demand is flatter than the market demand since consumers can substitute away from the dominant firm towards the since consumers can substitute away from the dominant firm towards the fringefringe

The outcome is, a price that is lower compared to the monopolistic caseThe outcome is, a price that is lower compared to the monopolistic case

Dominant Firm and Dominant Firm and Competitive FringeCompetitive Fringe

Dynamic PricingDynamic Pricing We need to develop the dynamic versions of the We need to develop the dynamic versions of the

dominant firm modeldominant firm model

The fringe’s ability to invest into more capacity The fringe’s ability to invest into more capacity grows with:grows with: Its Its retention ratio (from retained earnings)retention ratio (from retained earnings) The existing capacityThe existing capacity The price The price set by the dominant firmset by the dominant firm

For that reason, there is an additional pressure For that reason, there is an additional pressure for the incumbent to set lower current prices for the incumbent to set lower current prices since since current prices set by dominant firm affect current prices set by dominant firm affect fringe’s supply in the futurefringe’s supply in the future

Myopic PricingMyopic Pricing

Myopic pricing: set current price so as to Myopic pricing: set current price so as to maximize maximize currentcurrent profit profit

Dominant firm’s price decreasesDominant firm’s price decreases

Capacity of the fringe growsCapacity of the fringe grows

Reynolds Pen’s market share went down to Reynolds Pen’s market share went down to almost zero due to its high profit margins, but almost zero due to its high profit margins, but they made a lot of profit neverthelessthey made a lot of profit nevertheless

Limit PricingLimit Pricing Limit pricing: set the price so as to prevent Limit pricing: set the price so as to prevent

all fringe expansionall fringe expansion

Prevents the fringe from investing into Prevents the fringe from investing into additional capacityadditional capacity

Results in lower current profits, but higher Results in lower current profits, but higher profits in the futureprofits in the future

Depending on the discount rate, myopic pricing Depending on the discount rate, myopic pricing can be preferable to limit pricingcan be preferable to limit pricing

Optimal PricingOptimal Pricing Optimal pricingOptimal pricing

Start with the price above the limit pricing level Start with the price above the limit pricing level but below the one that maximizes the but below the one that maximizes the dominant firm’s current profitdominant firm’s current profit

Dominant firm’s price will keep on converging Dominant firm’s price will keep on converging to the limit pricing levelto the limit pricing level

The fringe grows to reach a certain level and The fringe grows to reach a certain level and then stops therethen stops there

Myopic, Limit and Optimal Myopic, Limit and Optimal PricingPricing

Profits for Limit and Myopic Profits for Limit and Myopic PricingPricing

Strategic CompetitionStrategic Competition

Re-cap: Structure-Conduct-Performance paradigmRe-cap: Structure-Conduct-Performance paradigm

We mentioned that firms’ behavior (conduct) can We mentioned that firms’ behavior (conduct) can affect the market structureaffect the market structure A dominant firm reduces price over time in order to A dominant firm reduces price over time in order to

constrain the growth of the fringeconstrain the growth of the fringe We now assume all firms in the market are large enough We now assume all firms in the market are large enough

to afford behaving strategicallyto afford behaving strategically

Examples of strategic behaviorExamples of strategic behavior Predatory pricingPredatory pricing Strategic entry deterrence (subject of this section)Strategic entry deterrence (subject of this section)

Bain-Sylos Model of Limit PricingBain-Sylos Model of Limit Pricing

Return to limit pricing, but assume no firm is a prReturn to limit pricing, but assume no firm is a price takerice taker

Bain-Sylos postulate: Bain-Sylos postulate: the entrant believes that, in the entrant believes that, in response to entry, each incumbent firm will contiresponse to entry, each incumbent firm will continue to produce at its pre-entry output ratenue to produce at its pre-entry output rate

The entrant only receives the residual demand thThe entrant only receives the residual demand that can be manipulated by the incumbentat can be manipulated by the incumbent

Residual Demand under Residual Demand under Bain-Sylos PostulateBain-Sylos Postulate

Deterring EntryDeterring Entry

Initially Initially allall firms in the industry have the long-run average cost curve AC firms in the industry have the long-run average cost curve AC

Output level by the incumbent equal to Qbar makes sure the residual demanOutput level by the incumbent equal to Qbar makes sure the residual demand for the fringe leaves no possibility for making positive profitsd for the fringe leaves no possibility for making positive profits

Critique of Bain-Sylos PostulateCritique of Bain-Sylos Postulate

Keeping incumbent’s output at the same level irrespectivKeeping incumbent’s output at the same level irrespectively of entry may not be necessarily the incumbent’s profitely of entry may not be necessarily the incumbent’s profit-maximizing strategy-maximizing strategy

According to Cournot’s theory, an incumbent will reduce itAccording to Cournot’s theory, an incumbent will reduce its output with more entrys output with more entry

Entry decision is independent of pre-entry output since thEntry decision is independent of pre-entry output since the post-entry demand and cost functions are independent e post-entry demand and cost functions are independent of the pre-entry past output decisions by the incumbentof the pre-entry past output decisions by the incumbent

Past and PresentPast and Present

Past output could affect current demand or costs:Past output could affect current demand or costs: Adjustment costs make it costly to change the level of outputAdjustment costs make it costly to change the level of output The more a firm produces today, the higher its profit-maximizing oThe more a firm produces today, the higher its profit-maximizing o

utput in the futureutput in the future Post-entry profits for the new entrants are less since the best-repPost-entry profits for the new entrants are less since the best-rep

ly function of the incumbent firm shifts outwardly function of the incumbent firm shifts outward

An incumbent firm may then deter entry by producing a suAn incumbent firm may then deter entry by producing a sufficiently large level of output prior to potential entryfficiently large level of output prior to potential entry

Bain-Sylos assumption then obtains when we assume infiBain-Sylos assumption then obtains when we assume infinitely large adjustment costsnitely large adjustment costs

Effect of Pre-Entry Output on Post-Entry Effect of Pre-Entry Output on Post-Entry Equilibrium Equilibrium

with Adjustment Costswith Adjustment Costs