Chapter 6: Market Structure Chapter 8: Competitive Strategy

1. 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 • Porter’s Five Forces Del Monte Fresh Pineapple Walmart, p. 221.

2. 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

3. Defining your marketQualitative approach • Product performance characteristics • Red roof inn, Motel 6 • Occasions for use • Coke and bottled water • Geographic market • Local; national; global

4. 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, 97,02) • 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

5. 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

6. Market structureconcentration measures • Concentration ratios (97 Economic Census) % of sales of the top n firms in each NAICS code • Herfindahl-Hirschman index (HHI) • 10,000 x The sum of squares of each firm’s fraction of industry sales • Monopoly HHI = 10,000 • Merger guidelines • < 1000 unconcentrated • 1000 < HHI < 1800 moderately concentrated • > 1800 concentrated

7. Definitions of Market Structures

8. 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

9. 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???

10. 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 P[1 - (1 / )] = MC (Factor out P; cancel Q’s) 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)

11. Monopoly: Markup and Profits P MC PM AC Markup A Average Cost of Producing Each Unit D B QM Q MR

12. 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

13. 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)

14. Perfect Competition: Long run Pricing After entry/exitMR = MC → firms use equimarginal thinkingP = min LRAC → so efficient productionNormal Profit = 0 economic profit

15. 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 Q1 Q QM Q Producer Surplus Producer Surplus MR

16. 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?

17. 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

18. Creating Value for Consumers A firm has market power if… ...it faces a downsloping demand curve. The firm’s pricing objective is… …to maximize shareholder value. The demand curve reflects… …consumer willingness and ability to buy. Consumer surplus = consumers’ gains from trade

19. Ways to create valueDel Monte Gold: A sweet example??

20. 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?

21. $5 reservation price $1.50 cost 1 pineapple $3.50 value created willingness to pay or reservation price Demand strategy Cost  Low cost strategy Q  Demand strategy Value created  Example: Pineapple value

22. If purchased at $3 Consumer surplus = $2.00 Producer surplus = $1.50 So firm only captures $1.50 of $3.50 value created… $5 reservation price $1.50 cost 1 pineapple $3.50 value created Example: Pineapple valuecontinued…

23. Porter’s five forces • Potential rivals • Existing rivalry • Substitute products • Buyer power • Supplier power Let’s go to the video tape

24. Superior factors of production • People • special talents or skills • Physical assets • prime real estate • unique equipment • But bidding for specialized assets may erode profits

25. Producer surplus captured by superior assets

26. 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

27. 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 company’s efforts to expand internationally?

28. Looking Forward • Assignment 2 • Due on October 14,18 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