Competitor Identification/ Mkt Definition

• Prerequisite for analyzing competition:

- identifying your competitors

- defining your market

Competitor Identification

• Identifying competitors by identifying substitutes

• Substitutes are products whose cross-price elasticities of demand are positive

• There is a distinction between direct and indirect competitors

• Similar products in different geographic markets may not be substitutes

Discussion question

What do you think is the Antitrust approach to market definition?

Market Definition

• Market definition describes the market in which a firm competes

• Two firms are in the same market if they constrain each others ability to raise price

• Suppose all firms collectively set prices to maximize combined profits. Would they choose to raise prices by a least 5%?

Market definition

• If the own-price elasticity of a group of firms collectively is small, then this group of firms constitutes a well-defined market

• Antitrust agencies (Dept of Justice) looks at the above

Market Structure and Competition

• Market structure refers to the number and distribution of firms in a market

• Common measures are N-firm concentration ratio and Herfindahl index

• The Herfindahl index of an industry depends on the nature of competition in the industry

A typology of competition

• Perfect competition:

- many sellers

- homogenous products

-well-informed consumers can costlessly shop around

A typology of competition• Monopoly:

-no competition for output

• Monopolistic competition:-many sellers

-each sells a differentiated product

• Oligopoly:-few sellers, so the actions of one firm

materially affects the others

Discussion question

What is more important: the attractiveness of an industry, or the position of a firm in an industry?

Industry attractiveness vs firm position

• Firm position is more important• What explains variation in firm profitability?

• The remaining unexplained percentage is random error

Source of variation % variation explained

Business-specific effects 32

Industry 19

Corporate parent 4

Year 2

A Tool for Assessing Industry Attractiveness: Porter’s Five Forces

Rivalry among Rivalry among existing industry existing industry

firmsfirms

Threat of substitute Threat of substitute productsproducts

BargainingBargainingpowerpower

of buyersof buyers

Bargaining Bargaining powerpower

of suppliersof suppliers

Threat of newThreat of new entrantsentrants

Performing the 5-forces analysis

• Assess each force by asking “Is it sufficiently strong to reduce/eliminate industry profits?”

• Internal rivalry-begin by defining market-price competition drives down prices-non price competition drives up costs-industry prices do not fall by themselves,

so you ask “Who will reduce it and why?”

Forces that drive down prices

• Many sellers• Stagnant or declining industry• Firms have different costs• Excess capacity• Undifferentiated products• Large/infrequent sales orders• Strong exit barriers• Prices/terms of sale unobservable• Prices cannot be adjusted quickly

Threat of new entrants

• Entry is pervasive. • Consider industry with 100 firms in 2005• Between 2005-2010, 40 new firms will enter • 30-40% turnover of firms, with 12-20% of volume• Entrants/exiters are smaller than estb. firms• Most entrants do not survive 10yrs• Entry and exit vary by industry, and are highly

correlated

Barriers to entry

• Structural

-control of essential resources

-economies of scale or scope

-marketing advantages of incumbency

• Strategic

Strategic barriers to entry

• First analyze entry conditions and choose entry-deterring strategy

• Entry conditions can be

-Blockaded

-Accommodated entry

-Deterred entry

Entry deterring strategies

• Limit pricing

-charge a low price before entry occurs

• Predatory pricing

-charge a low price after entry occurs

• Capacity expansion

Limit pricing

• Incumbent sets a low price

• Entrant infers that post-entry price would be low as well

• And so will not enter

• Is the potential entrant’s inference about post-entry pricing rational?

Limit pricing

• Uncertainty about incumbent’s post entry price might rescue limit pricing

• Uncertainty may be about

-Incumbent’s objectives

-Incumbent’s costs

-Level of market demand

• Does limit pricing really occur?

Predatory pricing

• Predatory firm sets a low price to drive (existing) competitors out of the market

• It then recovers any losses from the low price by being a monopolist

• It appears that predatory pricing is irrational in any finite-period interaction

• Yet, firms still do it

• Role of uncertainty and incumbent’s reputation for toughness in understanding paradox

Capacity expansion

• Do ‘large’ or ‘small’ firms have higher incentives to do it?

• Is it motivated just by efficiency, or by strategic desire to gain pricing-power through preemption?

Supplier power/buyer power

• Upstream suppliers have power if

-they are concentrated

-customers have relationship specific investments

-buyers do not buy large volumes

-they can forward-integrate easily

-they can price-discriminate

• Buyer power is just flip side of the above