B.  Competitors and Competition

1.  Pricing and output decisions for the firm

a.  Revenue

(1)  Total revenue

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(2)  Marginal revenue

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(3)  Demand and marginal revenue

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b.  Profit maximization

• Assume goal of the firm is to maximize profits

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2.  Identifying competitors

a.  SSNIP criterion

• All competitors identified if a merger among all of them would lead to a small but significant non-transitory increase in price

  • Small but significant = more than five percent

  • Non-transitory = at least one year

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b.  Substitutes

• Firms are competitors if a price increase by one causes loss of customers to another

(1)  Products have similar product performance characteristics

• What does product do for consumers?

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(2)  Products have similar occasions for use

• When, where, and how is a product used?

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(3)  Products sold in the same geographic market

• Two products are in same geographic market if:

(a) they are sold in the same location

(b) it is inexpensive to transport goods

(c) it is easy for customers to travel to buy goods

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c.  Measurement

• Cross-price elasticity of demand

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d.  Geographic competitor identification

• May not correspond to political boundaries

• Catchment area - contiguous area from which a firm draws most of its customers

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3.  Measuring market structure

• Look at number and distribution of firms in a market

a.  N-firm concentration ratio

• Combined market share of the N largest firms in a market

• Most common is the 4-firm concentration ratio

• 8, 20, and 50 also used

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• Not impacted by changes in the shares of the smaller firms

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b.  Herfindahl Index

• Also known as Herfindahl-Hirschman Index

Herfindahl = ∑ s_i²

s_i =market share of firm i

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• 2007 Economic Census

• Properties

- All firms considered

- More unequal market shares => higher index

- More firms => lower index

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4.   Market structure and competition

a.  Classifying market structure

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(1)  Concentration ratio

CR₄ < 40 => effectively competitive

40 < CR₄ < 60 => monopolistic competition

CR₄  > 60 => oligopoly

CR₁ > 90 => effective monopoly

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(2)  Herfindahl Index

Perfect competition - usually below 0.2 (or 2000)

Monopolistic competition - usually below 0.2 (or 2000)

Oligopoly - 0.2 - 0.6 (or 2000 - 6000)

Monopoly - 0.6 and above (or 6000 and above)

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• Department of Justice Merger Guidelines

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b.  Perfect competition

(1)  Characteristics

(a)  Many sellers

• No single firm has a large proportion of total production

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(b)  Homogeneous product - each product exactly the same

• Less consumer loyalty

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(c)  Full information on prices and products are available to consumers

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(d)  Free entry and exit

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(e)  Firms are price takers - accept the price established in the market

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Ex. - Agricultural, commodities, financial markets

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(2)  Profit maximization

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(3)  Long-run equilibrium

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(4) Factors leading to decrease in prices

• Need two or more of the following:

(a)  Many sellers

• Difficult to raise prices

i)  Diversity of pricing preferences

ii) Coordinated reduction in production needed

iii) Temptation to cheat and lower prices

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(b)  Consumers perceive product as homogeneous

• Customers more willing to switch if goods are homogeneous

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(c)  There is excess capacity

• High fixed costs => average cost decreases until capacity is reached

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(5)  Social efficiency of perfect competition

• Competitive equilibrium yields allocative efficiency - goods allocated optimally between producers and consumers

• Also productive efficiency - production at minimum of average cost => most cost efficient situation

• Efficiency not the same as equity - distribution of wealth and income not examined

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c.  Monopoly

• One seller of a product that has no close substitutes

• Firm faces little or no competition in its output market - due to barriers to entry

• Can set price without considering how other firms will respond

• Profit maximization:

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d.  Monopolistic competition

(1) Characteristics

(a)  Many sellers

• Each firm so small that actions will not affect other firms

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(b)  Products are differentiated

• Consumers make choices based on factors other than price

i)  Vertical differentiation

• Product unambiguously better or worse than competing products

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ii)  Horizontal differentiation

• Only some customers prefer a product to competing ones

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• Depends on idiosyncratic preferences - geography, styling, brand names

• Affected by search costs - how easy or hard is it to find alternatives

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(2)  Entry

• Profit attracts entry into an industry

• Price decreases, profits eventually driven to zero

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e.  Oligopoly

(1)  Characteristics

(a)  Few firms

(b)  Homogeneous or differentiated product

(c)  Actions by one firm will affect others in industry

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(2)  Modeling behavior

• Use game theory to model interdependence of firms

(a)  Basic elements

• Players - two or more participants (competitors, suppliers, customers, etc.)

• Actions - "strategies," choices that can be made by each player

- Simultaneous-move game - choices are made at the same time

- Sequential-move game - choices made at different times

• Payoffs - monetary or nonmonetary results

• Payoff matrix - indicates players, actions, payoffs

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(b)  Outcomes

i)  Nash equilibrium

• Each player does the best they can, given the strategies of the other players

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ii)  Dominant strategy

• One strategy optimal regardless of action taken by competitor

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iii)  Prisoners' Dilemma

• Players acting in their own best interest (i.e., employing dominant strategy) are worse off than if they had cooperated

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Ex. -  

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(c)  Game trees

• Used in sequential-move games

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• Subgame perfect Nash equilibrium - each player chooses an optimal action at each stage in the game, assuming the other player(s) do the same

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5.  Reasons for market structure

a.  Economies of scale and minimum efficient scale

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b.  Entry barriers

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c.  Product differentiation

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• Data shows that prices tend to be higher in concentrated industries

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