E.  Market Structure

1.  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?

Ex. -

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(2)  Products have similar occasions for use

When, where, and how is a product used?

Ex. -

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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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2.  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

Ex. -

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2012 Economic Census

- All firms considered

- More unequal market shares => higher index

- More firms => lower index

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3.   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) 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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(3)  Long-run equilibrium

If economic profits are made, competitors will enter until profits are eliminated

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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

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• Structural barriers to entry - incumbent has natural cost, marketing, or regulatory advantages

(1)  Control of essential resources

(a)  Control of a resource necessary for production

Ex. - DeBeers, Alcoa, Ocean Spray

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New input sources may emerge

Potential antitrust problems

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(b)  Patents

Competitors forbidden from using process or making product without permission for a certain period (20 years)

Competitors may try to "invent around" patents

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(c)  Specialized knowledge

Ex. - Coca-Cola, Ecke family

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(2)  Economies of scale and scope

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Entrant would have to engage in heavy promotion or price competition

Cost advantage from economies of scope too

- Economies due to multiple production lines, marketing of different brands

Ex. - Cereal

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(3)  Marketing advantages of incumbency

Umbrella branding

- Reduces uncertainty

- Distributors and retailers familiar with prior products

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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

Ex. -

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ii)  Horizontal differentiation

Only some customers prefer a product to competing ones

Ex. -

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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

Similar to perfect competition

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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) Economies of scale and minimum efficient scale

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(3)  Minimum efficient scale and market structure

If MES low compared to market demand => many small firms

If MES high compared to market demand => few large firms

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