Slide 1

Market Concentration and Its Key Indices

Market may be defined as one containing competing enterprises with large substitution possibilities on both production and consumption side i.e. large long run cross elasticity of either supply or demand

Purpose and properties of a useful Concentration IndexShould measure the ability of firms to raise prices above competitive levelsA higher value should indicate higher price cost margin (profit) or a higher likelihood of collusionExclusively Concerned with existing and actual competition and not potential competition (weak point)

Two Important measures: Concentration Ratio & Herfindahl Index (HHI)

Concentration Ratio

Most widely used ones are CR4 and the CR8.

It measures as below:CRm = s1 + s2+ .... + sm where si is the market share and m defines the ith firm

m-firm concentration ratio is the share of total industry sales accounted for by m largest firms

Fails to consider size distribution of firms and comparable industries

CR = 0% is pure competition and CR=100% is monopoly

does not provide details about competitiveness of the industry. It just indicates the degree of competition.

Herfindahl Index (HHI)..

Captures Size Distribution, It is Most widely used in antitrust and competition laws, one of key guideline tools for measuring merger effects of concentration on an Oligopolistic industry

Measures as , where si is the market share of firm i in the market, and N is the number of firms(normally leading upto 50 firms)

Ranges from 1 / N to one,. Equivalently, if percents are used as whole numbers, as in 75 instead of 0.75, the index can range up to 1002, or 10,000

Increases in the Herfindahl index generally indicates a decrease in competition and an increase of market power, whereas decreases indicate the oppositeHigher HHI (> 2500) implies higher concentration, lower competitionLower HHI (< 1500) implies Lower concentration, Higher Competition (Indian telecom Industry is considered to be amongst the fierce competitive market in the world with HHI round 1500)

As the market concentration increases, competition and efficiency decrease and the chances of collusion and monopoly increase

Lower the Marginal cost, higher the profit maximising output, higher the market share , thus a higher HHI and thus Higher Industry Price-cost margins (monopolistic behaviour)

Lerners IndexL = (p-MC)/pHighest in monopolyEqual to zero in perfect competitionRole of Indices in Anti-Trust Policy Collusion vs. Differential Efficiency HypothesisEmpirically, High Concentration Index signals High Profit margins. Collusion Hypothesis predicts that higher concentration cause Higher price-cost margins. It therefore yields an incentive to Collude to increase Profit margins.

Policy implication One should break up highly concentrated industriesIn contrast to the above, Differential Efficiency Hypothesis relies on Superior efficiency of firms to reduce their costs and increase their profits and thus secure larger market shares.

Empirically, more strongly supported Policy implication Dont break concentration by meaning penalisation of firms with superior efficiencyContestable marketsNew firms face no disadvantageInput pricesTechnologyKnowledge of demandZero sunk costs entry lag is less than price adjustment lagPrice competition with differentiated productsQ1=100-p1+b*p2Q2 = 100-p2+b*p1

S1 = p1q1-c*q1S2 = p2q2-c*q2dS1/dp1 = dS2/dp2 = 0P1=(100 +b*p2+c)/2P2=(100 +b*p1+c)/2

R1R2p2p1Strategic complementsP1* = p2* = (100+c)/(2-b)S1*=S2* = {(100+bc-c)/(2-b) } 2Profits increase with b, i.e. with more differentiation

Monopolistic competition

Equilibrium of the firmin the short and long run12Short run equilibrium of the firm under monopolistic competition Q OACMRAR DPsQsMC13Short run equilibrium of the firm under monopolistic competition Q OACMRAR DPsQsMCACs14Short run equilibrium of the firm under monopolistic competition Q OACMRAR DPsQsMCACs15Long run equilibrium of the firm under monopolistic competition Q OLRACMRLARL DLPLQLLRMC16Monopolistic competition

Comparison with perfect competition (long run)17Long run equilibrium of the firm under perfect andmonopolistic competitionQOP1LRACDL under perfectcompetitionQ118Long run equilibrium of the firm under perfect andmonopolistic competitionQOP2P1LRACDL under perfectcompetitionDL under monopolistic competitionQ2Q119Features of the four market structures

ForeignExchangeDoctorsSoft DrinkRailways20Price DiscriminationCharging different prices for a product when the price differences are not justified by cost differences.

Objective of the firm is to attain higher profits than would be available otherwise.

Price Discrimination1.Firm must be an imperfect competitor (a price maker)2. Some consumers must have a greater willingness to pay for the product than other consumers, and the firm must be able to know what prices customers are willing to pay.

3.Firm must be able to segment the market and prevent resale of units across market segments23 of 19Price Discrimination: Charging Different Prices for the Same ProductThe Requirements for Successful Price Discrimination

15 - 1Price Discrimination by a Movie Theater

24 of 19 How Dell Computer Uses Price Discrimination to Increase Profits

15 - 2LEARNING OBJECTIVE2

25 of 19Price Discrimination: Charging Different Prices for the Same ProductAirlines: The Kings of Price Discrimination

15 - 233 Customers and 27 Different Prices

26 of 19How Colleges Use Yield Management

15 - 1Do colleges practice price discrimination?

Dont Confuse Price Discrimination with Other Types of DiscriminationFirst-DegreePrice DiscriminationEach unit is sold at the highest possible priceFirm extracts all of the consumers surplusFirm maximizes total revenue and profit from any quantity soldSecond-DegreePrice DiscriminationCharging a uniform price per unit for a specific quantity, a lower price per unit for an additional quantity, and so onFirm extracts part, but not all, of the consumers surplusFirst- and Second-DegreePrice Discrimination

In the absence of price discrimination, a firm that charges $2 and sells 40 units will have total revenue equal to $80.Consumers will have consumers surplus equal to $80.First- and Second-DegreePrice Discrimination

If a firm that practices first-degree price discrimination sells 40 units, then total revenue will be equal to $160 and consumers surplus will be zero.First- and Second-DegreePrice Discrimination

If a firm that practices second-degree price discrimination charges $4 per unit for the first 20 units and $2 per unit for the next 20 units, then total revenue will be equal to $120 and consumers surplus will be $40.Third-DegreePrice DiscriminationCharging different prices for the same product sold in different marketsFirm maximizes profits by selling a quantity on each market such that the marginal revenue on each market is equal to the marginal cost of productionThird-DegreePrice DiscriminationQ1 = 120 - 10 P1 or P1 = 12 - 0.1 Q1 and MR1 = 12 - 0.2 Q1Q2 = 120 - 20 P2 or P2 = 6 - 0.05 Q2 and MR2 = 6 - 0.1 Q2MR1 = MC = 2MR2 = MC = 2MR1 = 12 - 0.2 Q1 = 2Q1 = 50MR2 = 6 - 0.1 Q2 = 2Q2 = 40P2 = 6 - 0.05 (40) = $4P1 = 12 - 0.1 (50) = $7Third-DegreePrice Discrimination

35 of 19Price Discrimination: Charging Different Prices for the Same ProductPrice Discrimination across Time

15 - 4Price Discrimination across Time

Transfer Pricing

Pricing of intermediate products sold by one division of a firm and purchased by another division of the same firmMade necessary by decentralization and the creation of semiautonomous profit centers within firmsPricing in PracticeCost-Plus PricingMarkup or Full-Cost PricingFully Allocated Average Cost (C)Average variable cost at normal outputAllocated overheadMarkup on Cost (m) = (P - C)/CPrice = P = C (1 + m)Pricing in PracticeOptimal Markup

Why Do Firms Use Cost-Plus Pricing?

Economists conclude that cost-plus pricing may be the best way to determine the optimal price when:

Marginal cost and average cost are roughly equal.

The firm has difficulty estimating its demand curve.

40 of 19Other Pricing StrategiesLEARNING OBJECTIVE3Odd Pricing: Why Is the Price $2.99 Instead of $3.00?

Many firms use what is called odd pricing.

Do consumers have an illusion that a price of $9.99 is significantly cheaper than $10.00?

There is some evidence that using odd prices makes economic sense.Pricing in PracticeIncremental AnalysisA firm should take an action if the incremental increase in revenue from the action exceeds the incremental increase in cost from the action.Pricing in PracticeTwo-Part TariffTyingBundlingPrestige PricingPrice LiningSkimmingValue Pricing43 of 19Other Pricing StrategiesPricing with Two-Part Tariffs

15 - 5A Two-Part Tariff at Disney World

44 of 19Other Pricing StrategiesPricing with Two-Part TariffsProfits per Day from Different Pricing Strategies at Disney World

15 2MONOPOLY PRICEFOR RIDESCOMPETITIVE PRICE FOR RIDESProfits from Admission Tickets$300,000$960,000Profits from Ride Tickets 360,000 0Total Profit 660,000960,000Because price equals marginal cost at the level of output supplied, the outcome is economically efficient.

All of consumer surplus is transformed into profit. Type of marketNumber of firmsFreedom of entryNature of productExamplesImplications for demand curve

faced by firm

Perfect

competitionVery manyUnrestrictedHomogeneous

(undifferentiated)Cabbages, carrots

(approximately)Horizontal:

firm is a price taker

Monopolistic

competitionMany / severalUnrestrictedDifferentiatedPlumbers, restaurantsDownward sloping,

but relatively elastic

OligopolyFewRestricted Undifferentiated

or differentiatedCement

cars, electrical appliancesDownward sloping. Relatively inelastic (shape depends on reactions of rivals)

MonopolyOneRestricted or completely blockedUniqueLocal water company, gas and electricity in many countriesDownward sloping: more inelastic than oligopoly. Firm has considerable control over price