1 ECP 6701 Competitive Strategies in Expanding Markets Oligopoly

2 Readings BDSS Chapter 6 pages and

3 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

4 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

5 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

6 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

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 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

10 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

11 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

12 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

13 Four Classes of Market Structure

14 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

15 Cournot Duopoly In the Cournot model each of the two firms pick the quantities Q 1 and Q 2 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)

16 Cournot Reaction Functions

17 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

18 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

19 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

20 Bertrand Reaction Functions

21 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

22 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

23 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

24 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