Market Structure and Strategic Competition

1. Market Structure and Strategic Competition Chapter 6

2. Key Concepts

3. Defining the Market • Ideal market definition should take into account the possibilities for substitution • If substitution across goods/services is easy, these goods/services should be considered one market • Production dimension • Geographical dimension • Substitution versus new entry • Substitution on the production side should be included only if the existing capacity can be shifted in the short run to produce those substitutes

4. Concentration Ratio • A fundamental problem with concentration ratios is they only discuss one point in the distribution of firms’ market shares • Depending on the number of firms, concentration ratios can be contradictory

5. Concentration: an Example

6. Herfindahl and Hirschman Index • HHI is defined as the sum of the squared market shares of all firms in the industry • In that way HHI includes information on all firms in the industry • HHI can be thought of as the average slope of the concentration curve in the industry (steeper slopemore concentration) • HHI maximum is attained at 10000 (a single producer) • Regulation authorities use the threshold of 1000 as critical

7. Concentration Curves: an Example

8. Concentration of Selected Industries

9. HHI and Policy • Empirical evidence has demonstrated the positive association of high HHI values with high price-cost margins • Why do we have this positive relationship? • Collusion hypothesis • Differential efficiency hypothesis

10. Minimum Efficient Scale • To achieve low unit costs, some firms need to engage in large-scale production • When efficient production scale (reached in the long run at the minimum of the average cost curve) is comparable to the market, there is only room for a few large firms in that industry • Specialization is usually cited as a major reason for firms to gain from large-scale production • However, empirical research has found most firms operate at larger scales compared to the minimum efficient scale • Is there any room for collusion here?

11. Minimum Efficient Scale

12. Entry Conditions • The number of active firms is determined by the ease of entry • Cost factor • Economies of scale • Entry conditions determine the extent of potential competition

13. Free Entry • Remember the present value of an infinite stream of benefits of equal nominal size for interest rate r is equal to the reciprocal of r (B/r, the taxi driver license example) • Suppose a firm’s profit in each year depends on the number of firms in a decreasing fashion • We can then identify the amount of firms in the industry given the entry costs • When entry costs increase, the equilibrium amount of firms under free entry decreases

14. Effect of the Cost of Entry on Equilibrium Number of Firms

15. Barriers to Entry • Barriers to entry are difficult to define • Are patents barriers to entry? • Will welfare increase if patent rights will be waived? • One definition of an entry barrier says: a barrier to entry may be defined as a cost of producing which must be borne by firms seeking to enter an industry but is not borne by firms already in the industry • The socially oriented definition says: socially undesirable limitations to entry of resources which are due to protection of resource owners already in the market

16. Scale Economies as Barriers to Entry • Entry may result in too much output that can only be sold at a price that is below average cost • Even if the new entrant produces a lower amount compared to the efficient one, the unit costs will be still too high for it making entry unprofitable in either case • Undercutting the incumbent may not work since consumers are normally loyal to the existing brands and advertising increases the entrant’s costs again

17. Scale Economies as Barrier to Entry

18. Contestability and Sunk Costs • A market is perfectly contestable if three conditions are met • Potential entrants have no technological disadvantage with respect to the incumbents • Zero sunk costs: all costs associated with entry are fully recoverable • The entry lag is less than the price adjustment lag for incumbents • If market is perfectly contestable, the equilibrium should entail a socially optimal outcome • Hit-and-run entry will result in the incumbent firm pricing at average cost • In this way sunk costs are barriers to entry

19. Dominant Firm Theory • There is one big firm and a large number of small price-taking firms • The dominant firm first selects the price which the fringe takes as given • The dominant firm’s residual demand is the difference between market demand and the fringe’s supply • At price P0, the fringe produces nothing so the dominant firm has all the market • The dominant firm prices at P* where its marginal revenue is equal to marginal cost • The dominant firm’s residual demand is flatter than the market demand since consumers can substitute away from the dominant firm towards the fringe • The outcome is, a price that is lower compared to the monopolistic case

20. Dominant Firm and Competitive Fringe

21. Dynamic Pricing • We need to develop the dynamic versions of the dominant firm model • The fringe’s ability to invest into more capacity grows with: • Its retention ratio (from retained earnings) • The existing capacity • The price set by the dominant firm • For that reason, there is an additional pressure for the incumbent to set lower current prices since current prices set by dominant firm affect fringe’s supply in the future

22. Myopic Pricing • Myopic pricing: set current price so as to maximize current profit • Dominant firm’s price decreases • Capacity of the fringe grows • Reynolds Pen’s market share went down to almost zero due to its high profit margins, but they made a lot of profit nevertheless

23. Limit Pricing • Limit pricing: set the price so as to prevent all fringe expansion • Prevents the fringe from investing into additional capacity • Results in lower current profits, but higher profits in the future • Depending on the discount rate, myopic pricing can be preferable to limit pricing

24. Optimal Pricing • Optimal pricing • Start with the price above the limit pricing level but below the one that maximizes the dominant firm’s current profit • Dominant firm’s price will keep on converging to the limit pricing level • The fringe grows to reach a certain level and then stops there

25. Myopic, Limit and Optimal Pricing

26. Profits for Limit and Myopic Pricing

27. Strategic Competition • Re-cap: Structure-Conduct-Performance paradigm • We mentioned that firms’ behavior (conduct) can affect the market structure • A dominant firm reduces price over time in order to constrain the growth of the fringe • We now assume all firms in the market are large enough to afford behaving strategically • Examples of strategic behavior • Predatory pricing • Strategic entry deterrence (subject of this section)

28. Bain-Sylos Model of Limit Pricing • Return to limit pricing, but assume no firm is a price taker • Bain-Sylos postulate: the entrant believes that, in response to entry, each incumbent firm will continue to produce at its pre-entry output rate • The entrant only receives the residual demand that can be manipulated by the incumbent

29. Residual Demand under Bain-Sylos Postulate

30. Deterring Entry • Initially all firms in the industry have the long-run average cost curve AC • Output level by the incumbent equal to Qbar makes sure the residual demand for the fringe leaves no possibility for making positive profits

31. Critique of Bain-Sylos Postulate • Keeping incumbent’s output at the same level irrespectively of entry may not be necessarily the incumbent’s profit-maximizing strategy • According to Cournot’s theory, an incumbent will reduce its output with more entry • Entry decision is independent of pre-entry output since the post-entry demand and cost functions are independent of the pre-entry past output decisions by the incumbent

32. Past and Present • Past output could affect current demand or costs: • Adjustment costs make it costly to change the level of output • The more a firm produces today, the higher its profit-maximizing output in the future • Post-entry profits for the new entrants are less since the best-reply function of the incumbent firm shifts outward • An incumbent firm may then deter entry by producing a sufficiently large level of output prior to potential entry • Bain-Sylos assumption then obtains when we assume infinitely large adjustment costs

33. Effect of Pre-Entry Output on Post-Entry Equilibrium with Adjustment Costs