Chapter 6: Market Structure Chapter 8: Competitive Strategy

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Chapter 6 Market StructureChapter 8
Competitive Strategy

• Review Assignment 1
• Market structure archetypes
• Defining your Market
• Perfect competition
• Monopoly
• Competitive Strategy
• Creating Value
• Capturing Value
• Porters Five Forces
• Del Monte Fresh Pineapple
• Walmart p. 221.

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Defining your market

• The boundaries of an economic market should
  include all the firms their products that
  interact to determine prices
• Analyze each of your markets separately
• Can use both qualitative quantitative methods
  for identifying competitors (i.e. substitutes)
• Geography may be important

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Defining your marketQualitative approach

• Product performance characteristics
• Red roof inn Motel 6
• Occasions for use
• Coke and bottled water
• Geographic market
• Local national global

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Defining your marketQuantitative criteria

• Demand elasticities
• Price elasticity
• higher look for lots of competitors
• Cross-price elasticity
• Strongly positive close substitutes
• Price correlations
• Airfares moving together
• SIC codes may help
• U.S. Census Bureau conducts Economic Census every
  5 years (92 9702)
• Firms are categorized according to type of
  product or service provided
• In each category firms sales payroll
  employees
• http//factfinder.census.gov/
• Example of SIC codes
• 311 Food mfctg
• 3112 Grain oilseed milling
• 31121 Flour milling malt manufacturing
• 31123 Breakfast cereal manufacturing
• Your market may not fit in neatly

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Market Structure

• Defined by attributes of the market environment
• Number concentration of the participating firms
• Characteristics of the product(s) they sell
• Affects behavior of participating firms
• Concentration
• As the degree of concentration increases it may
  be possible for firms to gain pricing advantage
  (but not necessarily)
• A measure of concentration is useful in
  describing the nature of a market

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Market structureconcentration measures

• Concentration ratios (97 Economic Census)
• of sales of the top n firms in each NAICS code
• Herfindahl-Hirschman index (HHI)
• 10000 x The sum of squares of each firms
  fraction of industry sales
• Monopoly HHI 10000
• Merger guidelines
• 1000
• 1800 concentrated

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Definitions of Market Structures
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Monopoly Mono opoly

• Strong barriers to entry single seller
• Product has no close substitutes
• Price maker (searcher)
• E.g. Prilosec by Astra-Merck in 1996
• Gasoline on Toll Roads

Barriers to entry

• Specific assets
• Economies of scale
• Excess capacity
• Reputation effects

• Pre-commitment contracts
• Licenses and patents
• Learning-curve effects
• Pioneering brand advantages

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Optimal Single-price Pricing

• Pricing objective maximize total profit
• MR MC for optimal output
• Optimal markup formula
• at optimal output Q
• Application The elasticity of demand for
  gasoline on the New Jersey toll road 10.
• What markup would a profit maximizing firm use

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Derivation of Optimal Markup Rule   From Profit
Maximization MR MC  Working with MR
side TR / Q MC (defn of MR)   (P Q Q
P) / Q MC (breakdown of TR)   P Q( P /
Q) MC (a little algebra)   Here comes
elasticity   P - Q(1 / )(P / Q) MC P1
- (1 / ) MC (Factor out P cancel Qs)
  Optimal markup rule P MC / 1 - (1 /
) (Divide by term) _________________________
__________________________ Need equation (1) for
the elasticity step above Defn. of elasticity
h (-1)(Q/Q) / (P/P) Multiply by
reciprocal (-1)( Q/Q)(P/P) Rearrange
(-1)( P /Q) ( Q /P) Solve for (-1) ( P
/Q) P /Q (-1)(1 / ) (P / Q)
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Monopoly Markup and Profits
P
MC
PM
AC
Markup
A
Average Cost of Producing Each Unit
D
B
QM
Q
MR
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Perfect competitioncharacteristics

• Many buyers and sellers
• Low seller concentration (each firm has low
  market share)
• Homogeneous product
• Low cost and accurate information about product
  and price
• Price taker
• Free entry and exit
• E.g. commodity markets agricultural products

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Entry and pricingperfect competition

• Above normal profit
• Attracts entry
• Increases market supply
• Reduces market price
• Reduces unit profit (P vs. ATC)
• Below normal profit
• Promotes Exit
• Decreases market supply
• Increases market price
• Over time increases unit profit (P vs. ATC)

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Perfect Competition Long run Pricing After
entry/exitMR MC firms use equimarginal
thinkingP min LRAC so efficient
productionNormal Profit 0 economic profit
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Monopoly Versus Perfect Competition
(b) Perfect Competition
(a) Monopoly
P
P
Consumer Surplus
Consumer Surplus
MC
MC
PM
P1
A
Deadweight Social Loss
D
D
Q
Q1
Q
QM
Producer Surplus
Producer Surplus
MR
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Application

• Pick a market/industry with which you are
  familiar. Based on your text reading how would
  you describe its market structure and why How
  narrowly/broadly are you defining the market
  (e.g. does Coke compete in all beverages or
  bottled soft drinks) How would you characterize
  barriers to entry to this market

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Strategy

• General policies intended to generate profits
• Choice of industry
• Combination of products and services
• Competitive and cooperative behaviors
• Strategies evolve as circumstances change
• Strategies must create and capture value

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Creating Value for Consumers

• A firm has market power if
• ...it faces a downsloping demand curve.
• The firms pricing objective is
• to maximize shareholder value.
• The demand curve reflects
• consumer willingness and ability to buy.
• Consumer surplus consumers gains
• from trade

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Ways to create valueDel Monte Gold A sweet
example
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Market Structure and Capturing Value

• Firms in competitive markets are price takers
• Market power and superior resources can lead to
  economic profit
• Going for the Gold and Pineapple Acid Test WSJ
• What are/were the barriers to entry into the
  premium pineapple market
• What is/will be the market structure of the
  premium pineapple market Profitability

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Example Pineapple value

• willingness to pay or reservation price
• Demand strategy
• Cost
• Low cost strategy
• Q
• Demand strategy
• Value created

• 5 reservation price
• 1.50 cost
• 1 pineapple
• 3.50 value created

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Example Pineapple valuecontinued

• 5 reservation price
• 1.50 cost
• 1 pineapple
• 3.50 value created

• If purchased at 3
• Consumer surplus 2.00
• Producer surplus 1.50
• So firm only captures 1.50 of 3.50 value
  created

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Porters five forces

• Potential rivals
• Existing rivalry
• Substitute products
• Buyer power
• Supplier power
• Lets go to the video tape

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Superior factors of production

• People
• special talents or skills
• Physical assets
• prime real estate
• unique equipment
• But bidding for specialized assets may erode
  profits

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Producer surplus captured by superior assets
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Superior factors of production

• Team production
• interdependencies among workers increase value
  beyond the sum of the parts
• luck or foresight may endow firms with unique
  team production capabilities
• Rivals may be unable to pinpoint source of
  advantage and unable to capture equivalent value

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Wal-Mart p. 221

• What is the impact of Wal-Mart.com on
  customer-borne transaction costs
• Do you think that Wal-Mart.com is likely to
  create additional value
• Is it likely that Wal-Mart will capture any value
  created by Wal-Mart.com
• Should Wal-Mart have pursued e-commerce more
  aggressively sooner
• What do you think the potential impact of
  Wal-Mart.com will be on the companys efforts to
  expand internationally

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Looking Forward

• Assignment 2
• Due on October 1418 or 19
• Read
• Managerial Economics
• Chapter 7 Pricing
• Coursepack
• The Power of Smart Pricing
• The Usual Decorous Waltz
• The Myth of Market Share
• Blackboard
• Why are Hotel Minibars So Expensive - Glenn
  Ellison