Economics 6034: Competition, Regulation and Business Strategy

1. Economics 6034: Competition, Regulation and Business Strategy Drs. Ka-fu Wong & Brett Norwood

2. Contact Information • Instructor: Brett Norwood • Office: KKL Room 923 • Phone: 2859-1049 • Email: bnorwood@econ.hku.hk • This is a really good way to get in touch with me • Office Hours: Thursday 1:30 - 3:30 Or by appointment

3. Contact Information • Instructor: Ka-fu Wong • Office: KKL Room 1002 • Phone: 2857-8512 • Email: kafuwong@econ.hku.hk • I bet this is a really good way to get in touch with him! • Office Hours: By appointment

4. Description • Topics for the first half of the course include: • Competitive Markets and Firm Strategy • Monopolies • State and Regulation • Antitrust Law and Competition • The Political Economy of Regulation • Rent Seeking and Collective Action • We will use numerous cases to illustrate these points in the second half of the course

5. Texts, Tests, Grades, etc. • Readings: Readings will include various articles and case studies; there is no text. • Grading: Project Report 70% Class Participation 30%

6. Course Web Site • The following class web site is kindly maintained by Dr. Wong; it will continue to be useful for you throughout the course. http://kafuwong.econ.hku.hk/teaching/econ6034/2005S/

7. Course Slides Please Note Some of these slides were previously used, edited or written by Prof. Richard Wong; they have since be edited or supplemented by me. Now, for some economics …

8. Competitive Markets & Firm Strategy

9. Basic Competitive Model • Based on rationality and maximizing behavior • Individuals weigh costs and benefits as they see them, making themselves as happy as possible (i.e., individuals maximize utility subject to resource constraints, such as time and money) • Different people have different preferences • Economists do not judge people’s preferences • Why do economists assume preferences do not change over time? • Firms maximize profits

10. Competitive Markets • Many firms selling identical products to many consumers • Firms and consumers are price takers in competitive markets • Each firm can sell as much as it wants: each is small compared to the size of the market • If they charge a price higher than the market price, they lose all their customers • All firms in the industry charge the same price.

11. Some Questions this Model Answers • What is produced, and in what quantities? • How are goods produced? • For whom are those goods produced?

12. Monopoly • At the other end of the spectrum is monopoly • A firm that is the sole provider of a good or service • One can compare equilibria under monopoly to perfect competition

13. Cost and Output for the (Single Pricing) Monopolist Cost,Price Marginal Cost Average Cost p2 Welfare loss Excess Profits p1 1 Demand MR Optimum Scale

14. Realistic? • Is this the way the world works? • Can you recall the five underlying assumptions of perfect competition?

15. Necessary Conditions for Perfect Competition • Homogeneous product • Distilled water versus mineral water • Many buyers (infinite) • Gold versus uranium • Many sellers (infinite) • Silver versus platinum • Free entry and exit • Fast food versus utilities • Equal information • Photocopy services versus medical treatment or legal advice

16. Markets and Competition • Economists have six main market categories • (Perfect) Competition • Monopolistic Competition • Loose Oligopoly • Tight Oligopoly • Dominant Firm • Pure Monopoly

17. Effective Competition • Effective competition in real markets occurs over a range of market conditions. • Pure Competition and Pure Monopoly are only polar cases. • In this course, we will try to focus on the messy reality • But don’t abandon your intuition – it’ll serve you well!

18. Michael Porter • Is sometimes thought of as one of the leading figures in the construction of modern business strategy theory • Provided a framework for thinking about a firm can gain a competitive edge in any given industry • Is there room for this in the basic competitive model?

19. ENVIRONMENTAL SCANNING General forces in the societal environment do not directly touch on the short-run activities of the organization, but influence its long-run decisions. • Economic forces regulate the exchange of materials, money, energy, and information. • Technological forces generate problem-solving inventions. • Political-legal forces allocate power and provide constraining and protecting laws and regulations. • Socio-cultural forces regulate the values, mores, and customs of society.

20. Task Environment • Elements in the task environment that directly affect the corporation include • governments • local communities • suppliers • competitors • customers • creditors • employees • and labor unions(!) • special-interest groups • trade associations

21. Industry Analysis • Industry analysis refers to an in-depth examination of key factors within a corporation’s task environment. • International societal environment presents issues for a multinational corporation.

22. Environmental variables

23. Important Variables in the Societal Environment • Economic • GDP Trends • Interest rates • Money supply • Inflation rates • Unemployment levels • Wage/price controls • Devaluation / revaluation • Energy availability and cost • Disposable and discretionary income

24. Important Variables in the Societal Environment • Technological • Total government spending for R&D • Total industry spending for R&D • Focus of technological efforts • Patent protection • New products • New developments in technology transfer from lab to marketplace • Productivity improvements through automation

25. Important Variables in the Societal Environment • Political-Legal • Antitrust regulations • Environmental protection laws • Tax laws • Special incentives • Foreign trade regulations • Attitudes toward foreign companies • Laws on hiring and promotion • Stability of government • Terrorism and privacy issues

26. Important Variables in the Societal Environment • Sociocultural • Lifestyle changes • Career expectations • Consumer activism • Rate of family formation • Growth rate of population • Age distribution of population • Regional shifts in population • Life expectancies • Birth rates

27. Scanning the External Environment

28. Issues Priority Matrix

29. INDUSTRY ANALYSIS: ANALYZING THE TASK ENVIRONMENT Threat of new entrants Rivalry among existing firms Threat of substitute products or services Bargaining power of buyers Bargaining power of suppliers (Relative power of other stakeholders)

30. Forces Driving Industry Competition(Porter’s Five Forces)

31. New Entrants • What is the Threat of New Entrants? • New entrants are a threat to an established corporation. • The threat of entry depends on the presence of entry barriers and the reaction that can be expected from existing competitors. • An entry barrier is an obstruction that makes it difficult for a company to enter an industry.

32. Possible Barriers to Entry • Economies of Scale. Scale economies in production give incumbent companies a significant cost advantage over any new rival. • Product Differentiation. Corporations create high entry barriers through their high levels of advertising and promotion. • Capital Requirements. The need to invest huge financial resources in production facilities creates a significant barrier to entry to any new competitor, i.e., problems due to asymmetric information and imperfections in capital markets. • Switching Costs. Once a standardized way of doing things becomes established, companies are very reluctant to switch to a new way because of the high training costs.

33. Possible Barriers to Entry (cont.) • Access to Distribution Channels. Small entrepreneurs often have difficulty obtaining supermarket shelf space for their goods because large retailers charge for space on their shelves and give priority to the established firms that can pay for the advertising needed to generate high customer demand. • Client Embedded Switching Cost. Microsoft's development of the first widely adopted operating system (MS-DOS) gave it a significant advantage over potential competitors that was cemented by the introduction of Windows. These created cost disadvantages for competitors that were independent of size. • Government Policy. Governments can limit entry into an industry through licensing requirements, for example, by restricting access to raw materials.

34. Example (Microsoft) • Barriers to entry for operating systems (OS) stem from a combination of economies of scale and network effects • Costs of applications programming is primarily in the creation of the software and are independent of the number of copies • Means there is an incentive to write applications for the largest platform • Network Effects arise when the attractiveness of a product increases with the use of that product by others

35. Rivalry • Rivalry is the amount of direct competition in an industry. • In most industries, corporations are mutually dependent. • A competitive move by one firm can be expected to have a noticeable effect on its competitors and thus may cause retaliation or counter-efforts.

36. Example • The entry by mail-order companies such as Dell and Gateway into the PC industry • Previously dominated by IBM, Apple, and Compaq • Increased the level of competitive activity • Any price reduction or new product introduction is now quickly followed by similar moves from other PC makers.

37. Factors Relating to Intense Rivalry • Number of Competitors. When competitors are few and roughly equal in size, such as in the U.S. auto and major home appliance industries, they watch each other carefully to make sure that any move by another firm is matched by an equal countermove. • Rate of Industry Growth. Any slowing in passenger traffic tends to set off price wars in the airline industry because the only path to growth is to take sales away from a competitor. • Product or Service Characteristics. Many people choose a video rental store based on location, variety of selection, and pricing because they view videos (tapes and DVDs) as a commodity – a product whose characteristics are the same regardless of who sells it. • Amount of Fixed Costs. Because airlines must fly their planes on a schedule regardless of the number of paying passengers for anyone flight, they offer cheap standby fares whenever a plane has empty seats.

38. Factors Relating to Intense Rivalry (cont.) • Capacity. If the only way a manufacturer can increase capacity is in a large increment by building a new plant (as in the paper industry), it will run that new plant at full capacity to keep its unit costs as low as possible – thus producing so much that the selling price falls throughout the industry. • Height of Exit Barriers. Exit barriers keep a company from leaving an industry. The brewing industry, for example, has a low percentage of companies that leave the industry because breweries are specialized assets with few uses except for making beer. • Diversity of Rivals. Rivals that have very different ideas of how to compete are likely to cross paths often and unknowingly challenge each other's position. This happens often in retailing.

39. Threat of Substitutes • Substitute products are those products that appear to be different but can satisfy the same need as another product. • Do you remember how to define substitutes in terms of elasticities? • Substitutes limit the potential returns of an industry by placing a ceiling on the prices firms in the industry can profitably charge. • If switching costs are low, substitutes may have a strong effect on an industry. • Identifying possible substitutes can be hard. • Products or services that can perform the same function may not appear to be easily substitutable at first glance.

40. Bargaining Power of Buyers • Buyers affect an industry through their ability to force down prices, bargain for higher quality or more services, and play competitors against each other. • Sources of bargaining power: • A buyer purchases a large proportion of the seller's product or service (Wal-Mart). • A buyer has the potential to integrate backward by producing the product itself. • Alternative suppliers are plentiful because the product is standard or undifferentiated.

41. Sources of Bargaining Power (cont.) • Changing suppliers costs very little. • The purchased product represents a high percentage of a buyer's costs, thus providing an incentive to shop around for a lower price. • A buyer earns low profits and is thus very sensitive to costs and service differences. • The purchased product is unimportant to the final quality or price of a buyer's products or services and thus can be easily substituted without adversely affecting the final product. • The supplier industry is dominated by a few companies, but it sells to many.

42. Bargaining Power of Suppliers • Suppliers can affect an industry through their ability to raise prices or reduce the quality of purchased goods and services. • A supplier or supplier group is powerful if some of the following factors apply: • Its product or service is unique or it has built up switching costs. • Substitutes are not readily available. • Suppliers are able to integrate forward and compete directly with their present customers. • A purchasing industry buys only a small portion of the supplier group's goods and services and is thus unimportant to the supplier.

43. Stakeholders • There are a variety of stakeholder groups from the task environment • Governments • Local communities • Creditors • Trade associations • Special-interest groups • Shareholders • Complementors. • A complementor is a company (e.g., Microsoft) or an industry whose product works well with a firm's (e.g., Intel's) product and without which the product would lose much of its value. • The importance of these stakeholders varies by industry • Their impact may vary for large or marginal producers.

44. Industries Over Time • Most industries evolve over time through a series of stages from growth through maturity to eventual decline. • The strength of each of the six competitive forces described above varies according to the stage of industry evolution • The industry life cycle is useful for explaining and predicting trends among the six forces that drive industry competition • This is similar to a product’s life cycle • (Can you use basic theory to determine the optimal advertising budget over the course of a product’s life cycle?)

45. Industries Over Time (cont.) • When an industry is new, people often buy the product regardless of price because it fulfills a unique need • This is likely to be a fragmented industry • an industry in which no firm has large market share and each firm serves only a small piece of the total market in competition with others

46. Industries Over Time (cont.) • As new competitors enter the industry, prices drop as a result of competition. • Companies use the experience curve and economies of scale (horizontal expansion) to reduce costs faster than their competition. • Companies vertically integrate to reduce costs even further by acquiring their suppliers and distributors. • Competitors try to differentiate their products from one another's to avoid the fierce price competition common to a maturing industry.

47. Mature Industries • Products tend to become more like commodities • Industries consolidate • Become dominated by a few large firms, each of which struggles to differentiate its products from the competition. • As buyers become more sophisticated over time, they base their purchasing decisions on better information. • Products become more like commodities in which price becomes a dominant concern given a minimum level of quality and features. As an industry moves through maturity toward possible decline, the growth rate of its products' sales slows and may even begin to decrease. To the extent that exit barriers are low, firms will begin converting their facilities to alternative uses or will sell them to another firm. The industry tends to consolidate around fewer but larger competitors.

48. Decline • The growth rate of products' sales slows and may even begin to decrease. • To the extent that exit barriers are low, firms will begin converting their facilities to alternative uses or will sell them to another firm. • The industry tends to consolidate around fewer but larger competitors.

49. Leading U.S. Firms Over Time Top 10 US Industrial Firms by Sales 1917 - 1988 1917 1945 1966 1983 1988 1 US SteelGMGM Exxon GM 2 Swift US Steel FordGMFord 3 Armour Stnd Oil Stnd Oil Mobil Exxon 4 Am. Smelting US Steel GE Texaco IBM 5 Stnd Oil Beth. Stl Chrysler Ford GE 6 Bethleham Stl Swift Mobil IBM Mobil 7 Ford Armour Texaco Socal Oil Chrysler 8 DuPont C-W US Steel DuPont Texaco 9 Am. Sugar Chrysler IBM Gulf Oil DuPont 10 GE Ford Gulf Oil Stnd Oil Philip Morris (Innovation!) http://www.quickmba.com/strategy/porter.shtml