business strategy for lawyers chapter 2: the strategic environment (competition) prof. amitai aviram...

Business Strategy for LawyersChapter 2:

The strategic environment (competition)

Prof. Amitai [email protected]

University of Illinois College of LawCopyright © Amitai Aviram. All Rights Reserved

S14D

The strategic environment (competition)Overview of Chapter 2

a) Economics of competition– Static analysis: supply & demand curves– Dynamic analysis: changes in supply & demand– Market power & constraints on pricing

b) Substitutionc) Entryd) Rivalrye) Supply chain

© Amitai Aviram. All rights reserved.2

Economics of competitionWelcome to business hell…

To understand competition, start in business hell:Perfect competition & marginal cost pricing


Economics of competitionThe concept of marginal cost

• Marginal cost (MC): cost of producing the next unit of the product• Example

– Producing one widget requires 1 person to work for 1 hour to assemble it– Wage: $4/hour– Raw materials: another $1/widget– Overhead cost: $3, regardless of

# of widgets produced (this couldbe rent, management costs, etc.)

Widgets Produced

Total Cost

Marginal Cost

0 $0 $8

1 $8 $5

2 $13 $5

3 $18 $5

4 $23 $5

5 $28


Economics of competitionHow low can you price?

• You are a widget producer in a competitive market• To get customers to buy your widgets, you must offer them the

lowest price possible• Of course, you can’t offer a price

so low that you’ll be better off notproducing the widget

• So, how low can you price?

Widgets Produced

Total Cost

Marginal Cost

0 $0 $8

1 $8 $5

2 $13 $5

3 $18 $5

4 $23 $5

5 $28


Economics of competitionHow high can you price?

• We now know how low a firm can sell its product

• But most firms are in business to earn as much as they can

• How high can the widget producer price its widgets?– Assume the market is perfectly

competitive (many firms identical to yours)


Economics of competitionProfitability in competitive market

• In a perfectly competitive market, P=MC• Suppose market price (P) is $5 (equal to MC):

• When will the firm be profitable?• Is there a reason to expect that market price would be higher than

$5?

Widget Output(Q)

Marginal Cost(MC)

Total Cost((MC*Q)+3)

Total Revenue(P*Q)

Profit (Loss)(T. Rev. – T. Cost)

4 $5 $23 $20 ($3)

5 $5 $28 $25 ($3)

6 $5 $33 $30 ($3)


Economics of competitionThe supply curve

• The supply curve shows the aggregate (market-wide) supplyof a product at a given price– I.e., how many units of the product would

be produced by all firms, if they could sell at that price

– Since firm produces if P≥MC, curve tracks the aggregate MC in the market

• Supply curve in our example– All firms had the same MC, so the supply

curve was flat

Price

(P)

5

Quantity (Q)

Supply curve of our

example (blue)


Economics of competitionThe supply curve

• But in the real world:– Different firms have different MCs– MC changes for the same firm as it

produces a different quantity• Typical “real world” supply curve

– Slopes downwards at first, as scale & experience improve the efficient use of resources

– Then slopes upwards as costs rise• Costs rise as resources are overused, or

less efficient resources are used• Lowest-MC firms form the beginning of

the supply curve, but costs rise as efficient firms reach their production capacity, higher-MC firms can sell, pushing the curve upwards

Price

(P)

5

Quantity (Q)

Typical “real world”

supply curve (gray)


Economics of competitionThe demand curve

• The demand curve showsthe aggregate demand forthe product at a given price

• Demand curves typically slope downwards– What causes the reduction in demand

as prices rise?

Price

(P)

Quantity (Q)

Demand curve (red)


Economics of competitionMeasuring demand

• Self-elasticity of demand:degree to which an increasein price reduces demand– % change in quantity demanded in

response to a 1% change in price– AKA price sensitivity

• E.g., hypo demand curve: P=11-Q– A decrease of $1 in price increases

demand by one unit– At P=$5, 1% P increase (to $5.05) lowers

Q to 5.95 (-0.05; -0.83% of 6)– So, at P=$5, Ed=-0.83

Price

(P)

5

11

116

Quantity (Q)

P=11-Q(red)


Economics of competitionSelf-elasticity of demand

• On one extreme is a perfectly elastic demand, such as P=5– Ed=-∞– Customers will buy an infinite

amount of the product at a price of $5, but will not buy even a single product at a higher price

• What can cause this elasticity?

Price

(P)

5

11

116

Quantity (Q)

Perfectly elastic

demand (blue)



• On the other extreme is a perfectly inelastic demand, such as Q=6– Ed=0– Customers will buy 6 units at any

price, but will not buy even a single additional product, no matter how low the price drops

• What can cause this elasticity?

Price

(P)

5

11

116

Quantity (Q)

Perfectly inelastic demand (green)



• Self-elasticity is measured empirically• However, major factors affecting it can be used as proxies (examples,

reducing elasticity):– No close substitute / product not commoditized

• E.g., famous artist’s painting, books, movies– Necessary purchase

• E.g., life-saving medicine– Price is not salient to customers

• E.g., restaurant menu– Purchase quantity/bundle not fixed

• E.g., selling in smaller boxes instead of raising prices• Harder to compare prices & to notice price changes



Real-world self-elasticity figures (source: Wikipedia)• Cigarettes: -0.3 to -0.6 (general); -0.6 to -0.7 (youth)• Alcoholic beverages

– -0.3 or -0.7 to -0.9 (beer); -1.0 (wine); -1.5 (spirits)• Airline travel: -0.3 (first class); -0.9 (discount); -1.5 (pleasure travelers)• Oil (world): -0.4• Car fuel: -0.25 (short run); -0.64 (long run)• Medicine: -0.31 (medical insurance); -.03 to -.06 (pediatric visits)• Transport: -0.20 (bus travel); -2.80 (Ford compact automobile)


Assume demand curve is: P=11-Q; supply curve is P=5 In perfect competition, market price

is where supply & demand curvesintersect (Here, at: P=$5, Q=6 units)

Market power (“MP”) The ability of a firm (or group of firms) to

charge >MC (i.e., above supply curve) Another definition of MP: ability to affect

market price or market output The more MP, the greater the firm’s

freedom to raise prices

Economics of competitionIntersecting supply & demand

Price

(P)

5

11

116

Quantity (Q)

Supply curve (gray)

6

5

Demand curve (red)


Even if firm has MP, it is constrained by the demand curve:higher P means lower Q Here, if firm can charge $6,

then P=$6, Q=5 units Higher self-elasticity means

MP is less profitable

Economics of competitionIntersecting supply & demand

Price

(P)

5

11

116

Quantity (Q)

Supply curve (gray)

6

5

Demand curve (red)


Economics of competitionDynamics: changes in demand

Price

(P)

5

11

116

Quantity (Q)

Demand curveRed: P=11-Q

More D - Green: P=13-Q

Less D - Blue: P=9-Q

6

75

4

A demand increase (demand curve shifts to the right) means that the value customers receive from the product has increased Note: cause of demand increase is

separate from issue of product’s price

If demand increases, quantity & prices rise

Likewise, if demand decreases (value from product is reduced), both prices & quantity fall


Economics of competitionDynamics: changes in supply

Price

(P)

5

11

116

Quantity (Q)

6

75

4

A supply increase (supply curve shifts to the right) means that the quantity producers can produce at a given MC has increased I.e., increasing capacity Note: again, this is unrelated to

the product’s price If supply increases, quantity rises &

price drops Likewise, if supply decreases (less Q

produced at a given MC), quantity falls & prices rise


Economics of competitionDynamics: cyclical markets

Some changes in supply/demand are unintentional, but many are intentional E.g., increase supply by building a new factory/expanding existing

factory; or increase demand by using product for more things than before

Intentional changes are often driven by prices E.g., if P goes down, customer may use product for more things; if P goes

up, producer may expand capacity But in some markets, there’s a lag between the decision to increase

supply/demand & the actual increase E.g., takes years to develop a new mine

Result: mismatches between supply & demand



Example: supply-driven cycle Demand increases

E.g., new industry requires copper P rises & Q rises (high profitability)

Producers expand capacity Build/expand mines Since new capacity takes years

to come on-line, shortage persists New capacity comes on-line

P drops & Q rises (profit down) Many capacity expansion plans still in progress – expensive to cancel, but

the excess capacity pushes prices down for long time



Cycle continued Profitability very low

Firms go bankrupt (some capacity lost) Other firms can’t afford to expand capacity Excess capacity disappears

Demand increases again But for years producers haven’t expanded capacity, so can’t respond to

demand quickly Shortage; prices rise quickly

Producers expand capacity And so on…

Should a producer avoid expanding capacity when a shortage occurs?


Economics of competitionDividing the value pool – No MP

• Customer surplus is the value of the product to the customer less the price the customer paid– When firms can only charge one price from

all customers, all customers except for the marginal one have some surplus

• Producer surplus is the price the customer paid less the marginal cost of the product to the firm– If firms have no MP (i.e., competitive

market in which all firms have same MC), there is no producer surplus

Price

(P)

5

11

116Quantity (Q)

Customer surplus

Supply curve (blue)

Total cost & total revenue

Demand curve (red)


Economics of competitionDividing the value pool – With MP

Price

(P)

5

11

116Quantity (Q)

Customer surplus

Total cost

6

5

Prod. surplus

• If MC=$5, but P=$6, then:– Fewer units produced & sold (6→5)– Customer surplus lower ($18→$12.5)

• One fewer widget to enjoy• Surplus from each purchased widget is

$1 lower (because widgets cost $1 more)

– Total revenue is unchanged: $30• Was 6x$5; now 5x$6

– But total costs lower ($30→$25)• Because fewer widgets are produced

– Remaining $5 are the producer surplus (profits)


• In the last example (value pool – with MP) we assumed that firm could charge $1 above MC; but how much above MC can firms actually charge?

• Consider an absolute monopolist– Assume that Congress passed a law that grants your firm (a widget

manufacturer) a monopoly in manufacturing & selling widgets in the U.S., and that bans widget importing

• No competition to undercut your prices!– Suppose that MC=$5– Should you charge $6? $6,000? $6M?

Economics of competitionValue as a pricing constraint


Economics of competitionValue as a pricing constraint

• Goodbye marginal cost pricing…– Monopolist’s price cannot be undercut by competitors– Therefore, the monopoly will raise its price above MC

• But there’s another constraint: higher price, lower demand– As P rises, Q drops (P>product’s value to customer)– Note: Monopolist can determine P or Q, but not both

• Hello marginal revenue pricing…– Firm will increase P to point that its profits are maximized (i.e.,

point where additional revenue from an increase in P is lower than the lost revenue from decrease in Q)

• Revenue = P x Q


Economics of competitionMarginal revenue pricing

• Example: Going back to the widget market, we use the demand function: P=11-Q (MC=$5, overhead costs = $3)

Widget Output

(Q)

Marginal Cost(MC)

Total Cost

(MC*Q+3)

Price

(P=11-Q)

Total Revenue

(P*Q)

Marginal Revenue

(TRQ+1-TRQ)

Profit

(T. Rev-T. Cost)

1 $5 $8 $10 $10 $8 $2

2 $5 $13 $9 $18 $6 $5

3 $5 $18 $8 $24 $4 $6

4 $5 $23 $7 $28 $2 $5

5 $5 $28 $6 $30 $0 $2

6 $5 $33 $5 $30 $-2 $-3

7 $5 $38 $4 $28 $-10

Total revenue is maximized when marginal revenue = marginal cost


Economics of competitionSupply reduction & deadweight loss

• Monopolist restricts output (6→3), in order to raise price ($5→$8), to the point where it maximizes profits ($0→$9, or $-3→$6 after overhead)

• Note the red triangle: it represents lost sales to customers who would have bought at $5, but won’t at $8– Would it be profitable to sell additional

widgets to those customers?– Why doesn’t the monopolist sell to them?

Price

Quantity

5

11

113 6

8Produc

er Surplus

Total Cost

Cons. Surplus


Economics of competitionMeasuring MP

• So, price ranges from MC in perfect competition to the monopoly price (price that makes MR=MC) in a monopoly, depending on how much MP the firm has

• But how do we measure MP?– Can we measure MP by observing how much the price exceeds MC?

• MP is like the wind – in itself it is invisible; we can only know of its existence by observing its consequences (e.g.,a breeze hitting our face, leaves whirling in the air)

• Can we identify MP by changes in prices/output?



• Example 1– A significant cost in manufacturing widgets is the cost of oil, which fuels widget-

producing machines– Oil has doubled in price in the past year; widget prices increased by 50%– People buy fewer widgets, reducing the number of widgets produced– Widget prices went up, output went down. Does this prove that widget

manufacturers have MP?• Example 2

– Springfield Nuclear Power Plant has alwaysbeen the only electric company in Springfield

– SNPP never raised its prices above the rateof inflation. Does this prove that SNPP hasno MP?



• Since we usually can’t identify MP just by observing prices & output, we need a tool to identify whether a firm possesses MP– This tool is competition analysis

• Competition analysis begins with a few (unrealistic) assumptions that, if true, indicate firm has absolute MP– It then examines how far the actual situation is from each assumption; the

closer reality is to the assumptions, the more MP the firm has


Economics of competitionThe forces that shape competition

• If the following assumptions were correct, a firm would have maximum MP:

1. No substitution: customers can’t substitute to another product that responds to same needs

2. No entry: other firms can’t adjust to offer the product3. No rivalry: firm is the only one offering the product4. No buyer/supplier power: suppliers’ & customers’ markets are

perfectly competitive• Since these assumptions are never entirely correct, each of these is

a force we need to evaluate to assess competition (i.e., how much of VP is allocated to firms in our market)


a) Economics of competitionb) Substitution

– Cross elasticity of demand– Proxies for cross-elasticity– Refining the substitution analysis

c) Entryd) Rivalrye) Supply chain



Cross-elasticity of demandCompared to self-elasticity

• Substitution is measured by assessing the cross-elasticity (“X-elasticity”) of demand– Self-elasticity: the degree in which a rise in the price

of Product A decreases demand for Product A• Affected by substitution (to all other products) & value

– X-elasticity: the degree in which a rise in the price of Product A increases demand for Product B

• Affected by substitution to a specific product


Cross-elasticity of demandExamples

• High X-elasticity: Exxon gasoline & BP gasoline– If Exxon & BP gas stations are similarly accessible, an increase in Exxon’s price

will cause some drivers to buy gas from BP, increasing demand for it• Moderate X-elasticity: (RTE) cereal & hot cereal

– If the price of ready-to-eat cereal increased, some people will buy other breakfast foods instead; some will choose hot cereal, increasing demand for it

• Low X-elasticity: Dogs & hot-dogs– Increase in the price of hot dogs will make some people opt for other foods– But a consumer who decides a hot dog is too expensive is unlikely to

use the money to buy more dogs

• McDonald’s & Burger King?• McDonald’s in NE Urbana & Burger King in Savoy?• Summer clothes in spring & summer clothes in fall?


Exxon/BP Gasoline

RTE/Hot Cereals

Dogs/Hot Dogs

Cross-elasticity of demandGeographic & temporal effects

• X-elasticity is affected by functional distinctions, but also by geographical & temporal distinctions

• Geographic distinctions– McDonald’s in NE Urbana & Burger King in Savoy– Jewelry store in NE Urbana & jewelry store in Savoy– When does geography matter?

• Temporal distinctions– Summer clothes in spring & summer clothes in fall– Watermelon during the season & watermelon off-season– When does time matter?


Cross-elasticity of demandWhy is it useful?

All beverages

Non-alcoholic beverages

Carbonated beverages

Beer

Water

Sprite

Coke

Pepsi

Cola beverages


Cross-elasticity of demandWhy is it useful?

All beverages

Recreational (“party”) beverages

Carbonated beverages Beer

Water

Sprite

Coke

Pepsi

Cola beverages

How can we determine which view is correct?I.e., which is the closer substitute to Coke – beer or water?


Cross-elasticity of demandUsing cross-elasticity

• How much X-elasticity is the threshold to be “in the market”?• To answer, think of the goal of market definition: to identify & assess

magnitude of MP– So, for Product B to be in the same market as Product A means that Product B

serves as a check on the ability of a monopolist in Product A to exercise MP (i.e., to profitably raise prices)

– So, we ask whether X-elasticity between A & B is sufficiently large that a monopolist of A who increases the price of A (traditionally, by 5%) will lose so many sales to B that its profits would decline (i.e., can’t exercise MP without also controlling B)


Cross-elasticity of demandUsing cross-elasticity: example

– Also assume profit margins are 90% (costs=10% of revenue)• Round 1: Is Pepsi in the market?

– Coke price up 5%; Coke’s lost sales: $20– Coke’s losses from lost sales: $18 ($20 x 90%)– Coke’s profits from price increase: $4 [(100-20) x 5%]– Coke lost $14; controlling all of Coke doesn’t give enough MP to make a 5%

price hike profitable– Conclusion: Pepsi is in the market

Assumptions Coke Pepsi Sprite Beer

Sales ($) 100 100 100 100

X-elasticity($ sales increase resulting from 5% increase in price of all products to the left)

N/A 20 15 10



• Round 2: Is Sprite in the market?– Coke & Pepsi price up 5%; lost sales: $15– Losses from lost sales: $13.50 ($15 x 90%)– Profits from price increase: $9.25 [(200-15) x 5%]– Coke-Pepsi lost $4.25; controlling all of Coke & Pepsi doesn’t give enough MP

to make a 5% price hike profitable– Conclusion: Sprite is in the market


Sales ($) 100 100 100 100


N/A 20 15 10



• Round 3: Is Beer in the market?– Coke, Pepsi & Sprite price up 5%; lost sales: $10– Losses from lost sales: $9 ($10 x 90%)– Profits from price increase: $14.50 [(300-10) x 5%]– Coke-Pepsi-Sprite gained $5.50; controlling all of Coke, Pepsi & Sprite gives

enough MP to make a 5% price hike profitable– Conclusion: Beer is not in the market


Sales ($) 100 100 100 100


N/A 20 15 10


Cross-elasticity of demandWhy use a 5% price increase?

• Antitrust regulators are concerned if MP allows firm to profitably sustain a “small but significant, non-transitory increase in price” (SSNIP)– They consider 5% to be SSNIP

• You can replace that figure with whatever level of MPyou are interested/concerned about– E.g., if you want to check what market needs to be

controlled to allow firm to raise prices by 50%, calculateX-elasticity for a 50% price increase


Cross-elasticity of demandThe cellophane fallacy

• We found that a firm controlling Coke, Pepsi & Sprite has MP to raise prices by 5%– Suppose that Acme is the only producer of all three beverages. Naturally, it

chooses to raise prices by 5%.• Acme then examines what would happen if it raised prices by

another 5%– If it finds that it makes a profit from an additional price increase, it will increase

prices further– If it finds that it loses money from an additional price increase, it will keep

prices where they are• Result: Acme raises prices until x-elasticity with Beer is sufficiently

high to make a future price increase unprofitable• If we look at x-elasticity at this point, would we say that Beer is in the

same market as Coke, Pepsi & Sprite?


Cross-elasticity of demandThe cellophane fallacy

• Called “cellophane fallacy” because it came up in an antitrust case (U.S. v. duPont), that dealt with cellophane

• Solution to the cellophane fallacy:– X-elasticity must be calculated not at the existing price level, but at the

price that would provide only normal profits• But it is hard to calculate X-elasticity at fictitious prices

– Evidence on X-elasticity should be treated with greater skepticism a firm has significant MP in the defined market

• If a firm is earning supra-competitive profits, the X-elasticity figures are likely to be overstated (and thus other products will seem to be better substitutes than they actually are)



– Cross elasticity of demand– Proxies for measuring substitution– Refining the substitution analysis




Proxies for substitutionTools other than cross-elasticity?

• The advantage of X-elasticity as a market definition tool is that it can be empirically measured– Disadvantages of using X-elasticity to define markets?

• To overcome X-elasticity’s shortcomings, we need proxies for X-elasticity that can be used to:– Narrow the list of products that are likely to be part of the same market (so we

can focus the X-elasticity analysis)– Replace X-elasticity where data is unavailable or expensive to acquire


Proxies for substitutionBaker, Market definition: an analytical overview

1. Evidence of past buyer response to price change2. Buyer surveys (of their expected response to price change)3. Product/geography characteristics that matter to buyers

– E.g., shipping costs & geographical distribution of buyers– This is similar to our concept of customer benchmarks

4. Conduct of (supply-side) market participants– E.g., extent to which firms track & respond to price changes or product

introductions of rivals5. Views of market experts

– More valuable if experts have access to primary information & if they base costly business decisions on that information


Proxies for substitutionBrown Shoe Co. v. U.S.

• Intended to detect a sub-market in a larger market1. Industry recognition

– Similar to Baker’s points 4 & 52. Product’s characteristics & uses

– Similar to Baker’s point 33. Unique production facilities

– What prevents manufacturer of product A from producing B?– Essentially tracks supply substitution (entry)

4. Distinct customers5. Sensitivity to price changes

– Similar to Baker’s points 1&26. Specialized vendors


Proxies for substitutionGeroski & Porter

• Geroski, Thinking creatively about your market– Defines market as viable ways to satisfy a need– Need + economic viability replace direct proxies for buyer substitution1. Identify a need

• Figure out how the need can be supplied (i.e., how a product can satisfy customer benchmarks)

2. Is this a viable activity?• Consider demand, rivals, substitutes, etc.• Identify strategic necessity (minimum viable scale/scope)

3. Identify strategic options• To differentiate your product from rivals’ products

• Porter, The five competitive forces– Products are in same market if their market structure is similar

• I.e., if the five forces operate on them in similar ways (similar buyers, suppliers, barriers to entry, etc.)

• Buyers, suppliers, entry, rivalry & substitution replace only substitution (conflicts with Baker’s views)

– Porter’s rule of thumb: Separate markets if activities differ in multiple forces or differ significantly in any one force


Proxies for substitutionSummary

• Direct evidence of buyer response to price change is the closest proxy to X-elasticity, if future is expected to be similar to past & if data is of good quality

• Customer benchmarks (from basis of competition analysis)• Producer behavior (who do they track & respond to?)

– But filter for producers’ PR incentives• Views of industry experts

– If they have access to primary information & if they base costly business decisions on that information



– Cross elasticity of demand– Proxies for measuring substitution– Refining the substitution analysis

• Cluster markets• Switching costs• Current substitution threat




Refining substitution analysisCluster markets

• Are left shoes & right shoes good substitutes?– X-elasticity: If price of left shoes rises, do people buy more or less right shoes?

• Why do we have a shoe market (as opposed to left & right shoe markets)?

• This issue comes up for many complementary products that are sold as bundles– E.g., Car market vs. markets for car engines, car bodies, steering wheels, etc.– Why are these components always sold in a bundle?– It gets more complicated when same customers buy both bundled &

unbundled products (e.g., wheels)


Refining substitution analysisCluster markets

• Advantage of using cluster market– Simplicity – if products almost always sold in a bundle, all products respond in

same way, so we treat them as one• Problem with using cluster market

– Suppose dogs & hot dogs are considered one cluster market– Acme has a 0 share of the $95 M dog market (sells no pets), but has an 80%

share of the $5M hot dog market• In total, it has a 4% share of the dog & hot dog market

– Does Acme have MP under the cluster market definition?– Does Acme have MP in reality?


Refining substitution analysisSwitching costs

• Examples– Gyms with childcare: Children get used to particular childcare service; insulates

gym from competitive pressures– Cellphone exclusivity: If mobile phone service uses exclusive phones, switching

phone service requires buying a new phone• Effect on the strategic environment

– Substitution: high switching costs reduce/eliminate substitution after customer selects a particular product

– Entry: switching costs increase entrant’s costs to capture new customers, so they reduce potential profits & require more time to reach MES (if economies of scale are a BTE)

– Rivalry: reduces competition over existing customers (firms compete on new customers)• Switching costs reduce rivalry more in mature markets (because mature

markets have fewer new customers)• Increases impact of information asymmetries/marketing


Refining substitution analysisCurrent substitution threat

• Once market is defined, identify the closest substitutes to your “starting point” product

– Some products in market are greater substitution threat than others– Same measurements used to define markets are used to identify closest

substitutes (X-elasticity & its proxies)

• Degree of substitution with the closest rivals is:– An indicator of the current substitution threat– Identifies firms to focus on in rivalry & firm-level analysis


Refining substitution analysisMarket definition: review

• Pepsico v. The Coca-Cola Co.: Pepsi’s market definition: fountain soda distributed by independent foodservice distributors (IFDs)

1. Is fountain soda a separate market from other soda?2. Is soda distributed by IFDs a separate market from soda distributed via

bottlers?


Refining substitution analysisMarket definition: review

• Is soda distributed by IFDs a separate market from soda distributed via bottlers? Court: no– IFDs provide more value, but bottlers can compete by price

• Are premium & value products in the same market?– Coke does not have MP in distributing soda

• Of the cola syrup distributed to Coke’s top 50 restaurant accounts, Coke’s company-owned outlets accounted for only 27.5%

– If soda via IFDs is a separate market from soda via bottlers, then Pepsi & Coke aren’t rivals (at least regarding customers who use IFDs)

• Since Pepsi used bottlers & Coke uses IFDs


SubstitutionTeam project: market definition

• Each team should pick one establishment on campus that offers food– Conduct research to define the market that centers on this establishment– E-mail your team report to me (1 e-mail per team)

• Process of the project1. Select a starting point (very narrow – one specific establishment)2. Identify (based on evidence) the bases of competition

• Customer needs & customer benchmarks3. Substitutes

• Identify potential substitutes• Find evidence regarding the degree of substitution with your starting point

4. Conclusion: Which businesses are in the relevant market? Which are the closest substitutes

• For all evidence you use:– Describe how it was collected– Describe the evidence & its implication on your analysis– Conduct a reliability assessment (weaknesses / blind spots of the data)


a) Economics of competitionb) Substitutionc) Entry

– Economies of scale & scope– Access to inputs & complements– Imposing disproportional costs

d) Rivalrye) Supply chain



EntryTypes of BTE

• Key question regarding entry: If a firm’s product is profitable, why aren’t other firms copying the firm?

• Common reasons:– Economies of scale & scope– Access to inputs & complements– Other actions that impose disproportional costs on rivals


Economies of scale & scopeWhat are economies of scale?

• Economies of scale (in supply): cost per unit drops as production increases

• Measuring cost per unit– Variable costs (VC): costs that vary w/quantity produce

• E.g., raw materials, hourly wages for labor– Fixed costs (FC): costs that don’t vary w/quantity produced

• E.g., rent, administrative costs– Marginal cost (MC): cost of producing next unit (next unit’s VC + new FC)– Average variable costs (AVC) = Total VC/Q

• Cost of past, not future, units• Does not include marginal FC• Sometimes used as a proxy for MC

– Average total cost (ATC) = (Total FC + Total VC)/Q• Cost of past, not future, units• Includes all FC, not just marginal ones


Economies of scale & scopeCommon causes of supply-side economies

• High FC compared to VC– FC can be spread over more units if production increases– Example: Production of steel involves large changes in temperature (from room

temperature to very hot). Heating and cooling must be gradual, or the machinery will break. Therefore, turning production on or off requires hours of warming up/cooling down. Since most of the cost of production is energy for the machines & wear on the machines (which will occur anyway), might as well spend the raw materials and make the product.

• Experience/learning curve– Employees get better at what they do– Find ways to improve production process & product design


Economies of scale & scopeExample

• You are a widget producer; market price for widgets is $6• Producing a widget:

– 1 employee operating 1 machine takes 1 hour to produce a widget• Employee’s wage: $4/hour• Machine is wind-powered – no energy costs

– Raw materials cost another $1 per widget– Rent for the factory is $10/day (regardless of # of widgets produced)

• How much is the AVC?• Based on these assumptions, how many units do you need to

produce to minimize ATC?


Economies of scale & scopeExample: add capacity constraints

• It is only windy 4 hours/day– The rest of the day you can’t use your machines

• Factory only has room for 5 machines– So, wind-powered machines in your factory can produce up to 20 widgets/day

• To produce more than 20 widgets/day, employees must produce them manually– This takes longer: 2 hours per widget

• How much is the AVC for manual production?• With market price @$6, firm maximizes profits @ 20 widgets

– Above that, it loses $3 on each widget sold ($6-$9)• Quantity in which ATC is lowest is called Minimum Efficient Scale

(MES) or Minimum Viable Scale (MVS)


Economies of scale & scopeExample

-15

-10

-5

0

5

10

15

20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26

Profit Avg. TC


Economies of scale & scopeImpact on entry

• MES impacts the feasibility of entry into a market– If you can’t get your market share up to the MES, then you’ll have higher

production costs than rivals & gradually lose sales to rivals• Example

– In our hypo, MES is 20 widgets– Assume that total demand for widgets is 18 & Acme currently supplies the

entire demand– Ajax expects to “capture” orders for 4 widgets

• Ajax’s costs: $10 + 4x($1+$4) = $30 ($7.50/widget)• Acme’s costs: $10 + 14x($1+$4) = $80 ($5.71/widget)

– Ajax will lose if it prices below $7.50; Acme can price much lower, so it can capture back the 4 widget orders by offering a price below $7.50


Economies of scale & scopeImpact on entry

• Analogy to climbing up a slippery slide– Slide length: MES / entrant’s initial sales

• If 100% or less, no problem for entrant• If over 100%, entrant needs to capture additional sales to equalize costs• Particularly significant when switching costs are high (e.g., long-term contracts)

– Slide steepness: ATC @ entrant’s initial sales / ATC @ MES• When entrant reaches MES, this is 100%• Amount in excess of 100% represents entrant’s

cost disadvantage compared to incumbent whoalready reached MES

• How can a firm that operates below MES survive?


http://images.google.com/imgres?imgurl=http://www.jdbard.com/images/Owen/2006/Spring06/May/Owen_May_climbing%20up%20the%20slide.JPG&imgrefurl=http://www.jdbard.com/spring_06.htm&usg=__7tVPtORaejUjTVNOYYKgiLX6wHA=&h=640&w=480&sz=143&hl=en&start=23&um=1&tbnid=f9QOqDLgOVd7yM:&tbnh=137&tbnw=103&prev=/images?q=climbing+up+the+slide&ndsp=18&hl=en&rls=com.microsoft:en-US&sa=N&start=18&um=1

Economies of scale & scopeSurviving below MES

1. Find a niche (differentiation)– Consider earlier hypo, but add:

• Acme is in Chicago; Ajax locates itself in Champaign• There’s a $3/widget transportation cost

– For Acme, selling a widget in Champaign has MC of $8($4 labor, $1 raw materials, $3 transportation)

– Ajax’s ATC is $7.50, so Ajax captures sales in Champaign– Note: entrants (like Ajax) consider whether they can sell above ATC;

incumbents (like Acme) consider whether they can sell above MC (or AVC), because they already spent the fixed costs

2. Displace the incumbent (confrontation)– If customers are swayed just by price & Ajax has enough cash to burn, it can

price @ $5.56 (ATC @18 units), which is below Acme’s ATC ($5.71) – once it captures more customers than Acme, it has lower costs & Acme might be pushed out of the market (or forced to share it)

3. Bring antitrust suit/regulatory action (confrontation)© Amitai Aviram. All rights reserved.69

Economies of scale & scopeSurviving below MES

4. Reach an understanding to respect each firm’s turf (coordination)– May violate antitrust laws

5. Grow the market (value pool)• If Ajax can increase total demand by 10, it will have 14 & Acme will

have 14 (so their costs will be the same)• But what stops Acme from stealing the new customers?

– Differentiation/coordination/confrontation– Costs beyond MES

• Costs start rising when producing above the MES; when they exceed costs of firms producing below MES, a small firm can survive below MES

• Example– Assume total demand is 34– If Ajax sells 14, ATC=$5.71; Acme then produces 20 widgets, w/ATC=$5.50– If Acme produced widget 21 manually then MC=$9, so Acme won’t try to sell it

for less than $5.71 & push Ajax down to 13 widgets


Economies of scale & scopeCosts beyond MES

• What happens to costs beyond MES affects market structure– If costs climb steeply beyond MES (as in hypo & red graph below), larger firms

won’t grow much above MES; small firms capture niches– If costs climb mildly beyond MES (as in blue graph below), firms will tend to

grow above MES; small firms are unlikely (unless price is less important than other bases of competition)

$5.00

$5.50

$6.00

$6.50

$7.00

$7.50

5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39

$5.00

$5.50

$6.00

$6.50

$7.00

$7.50

5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39


Economies of scale & scopeMES & number of rivals

• Number of firms in the market is influenced by the ratio: MES/total demand– If ratio ≥ 100%, market is a natural monopoly (only 1 firm likely to survive)– If 100% ≥ R ≥ 50%, no more than 2 firms likely to survive

• 1 firm, if costs don’t rise much above MES (e.g., blue graph)– If 50% ≥ R ≥ 33%, no more than 3 firms likely

• 1 or 2 firms, if costs don’t rise much above MES– If 33% ≥ R ≥ 25%, no more than 4 firms likely– Etc. …


Economies of scale & scopeEconomies of scale in demand (NW effects)

• Until now we considered economies of scale in supply• Economies of scale can also exist in demand (in which case they are

called network effects), if the value to a user of the product increases as other’s use of the product increases

• Example 1: phones– A telephone is useless if only one person uses it– Benefit increases the more people have a phone

• Example 2: credit cards– If more people carry a given credit card, more merchants will accept it– If more merchants accept a card, more people want to carry that card– Each additional cardholder benefits all existing cardholders & merchants

affiliated with that credit card brand



• Example 3: electric cars & charging stations– Presence of charging stations increases the value of owning an electric car;

presence of additional electric cars increases profitability of a charging station• Examples 2 & 3 exhibit indirect network effect: additional use of one

product spurs demand for a complementary product– Such effects are common in multi-sided platforms (MSPs): products that allow

direct interaction between 2 or more types of customers– E.g., credit cards (shoppers <-> merchants); newspapers (readers <-> advertisers)

• Do these have network effects?


Facsimiles Online markets Word Processors

Soda Dispensers


• Almost every market has some network effects, because almost every product has complements (e.g., product & distribution of the product)

• Factors that make network effects a significant BTE include:– Difficult to quickly create/expand rival networks (cf. soda dispensers)– High added value from complement (cf. word processing without file-sharing)– High switching costs between networks– Member can’t be on multiple networks (cf. gas stations)

• Aggregators can facilitate multi-network membership (e.g., Orbitz)– Centralized control of the network (cf. open access standards)

• Network effects as a BTE– Entrant disadvantaged if not part of large (existing) network; example:

• QWERTY keyboard (c. 1868) designed to minimize jamming of type bars• Dvorak keyboard (1936) designed to maximize typing speed• Paul David (1985) cites this as an example of network effects as BTE of a superior standard• Liebowitz & Margolis (1990) present a murkier picture; not clear which standard is superior


Economies of scale & scopeEconomies of scope

• Economies of scope in supply– ATC drops if several products produced by same firm/plant– E.g., multiple sections in a newspaper; producing petrochemicals when refining oil– BTE: costs higher for an entrant who doesn’t produce both products

• Economies of scope in demand– Value increases if several products are purchased together– Examples: one-stop shopping; buying car body & car engine from same firm– BTE: lower value to product of entrant who doesn’t offer both products

• Producer can either make both products, or make one & get access to the other (e.g., buying engines from a supplier; sharing a store with another retailer)


EntryAccess to inputs & complements

• Inputs are raw materials/services required to produce a product• Complements are products consumed together with other products

– Example: tablet & cellphone network access– Example: gas & gas retailing at a station

• Quantitative test for whether C is a complement– Assume that the price of C increased by 10%– If demand for A decreased – C is likely a complement– If demand for A increased – C is likely a substitute

• Inputs/complements include (non-exhaustive list):– Distribution of a product– Capital (ability to get funding for the business)– Product’s branding/image (therefore, product differentiation creates a BTE)– Land in a particular location (matters particularly in retailing, hotels, etc.)– Proprietary technology & know-how used to make the product– Legal right to provide the product (so law/regulation can be used as a BTE; e.g.,

zoning laws, professional licensing regulations, health/safety regulations)© Amitai Aviram. All rights reserved.77

EntryAccess to inputs & complements

• Access to inputs & complements as a BTE– Control of an essential facility (the only source for the complement)

• E.g., the only viable supply/distribution channels– Control of the most efficient/cheapest complements

• Example 1: Power plants need coal. Plant A owns all local coal producers. Plant B must buy coal from further away, paying more for transportation.

• Example 2: Coke’s exclusivity agreements with IFDs. Court rejected Pepsi’s claim that this violated antitrust laws, but it did give Coke an advantage.

• Network effects in a MSP create a BTE that can be classified as both economies of scale (in demand) & an access to complements issue– E.g., if Visa cards are accepted by many merchants, the restriction on new entry

can be framed as either Visa’s greater value due to economies of scale in demand, or as entrants’ restricted access to a complement (merchants that accept the credit card)


EntryOther actions that impose disproportional costs

• Actions that impose lower (or no) costs on one firm (F) than a rival firm (R) can deter R from entering a market

• Legislation / government regulation– E.g., advertising restrictions benefit known incumbents at expense of entrants– Powerful way to create a BTE, facilitate coordination or confront rivals

• Doesn’t violate antitrust laws• Government pays for enforcement, imposes costs on rivals who object• Less reputational harm (has government’s seal of approval)

– Even when government does adopt your preferred regulatory position, its investigation may impose expenses disproportionately on your rivals

• Litigation– Litigation often imposes costs disproportionately on parties

• One side has greater discovery & trial costs• One side has more potential for PR harm from discovery & trial• One side suffers greater harm from delay caused by litigation

– Threat of litigation can serve as a BTE; actual litigation can be a form of confrontation© Amitai Aviram. All rights reserved.79

EntryOther actions that impose disproportional costs

• Regulation (and legal issues more generally) are a common barrier to entry because there is an inherent imbalance in lobbying for particular regulation: incumbents know exactly what regulation would be advantageous for them, and know how much is financially at stake for them, so they can spend accordingly on lobbying– In contrast, many potential entrants do not know what markets they will enter

and care to lobby on, and may consider several markets but only enter one of them. Also, there is uncertainty what their interests are (e.g., will they be a small player in the market or a big one?) and how much is at stake. This reduces their incentive and effectiveness in lobbying.

– As a result, law is likely to often favor incumbents


a) Economics of competitionb) Substitutionc) Entryd) Rivalry

– Propensity for differentiation– Propensity for coordination– Propensity for confrontation

e) Supply chain



RivalryRivalry as a prisoner’s dilemma

• Two people are arrested. Prosecutor has evidence to convict both for illegally possessing guns (3 yr. sentence). Prosecutor also suspects both participated in a robbery (10 yr. sentence), but doesn’t have enough evidence to convict unless at least one confesses.– Prosecutor offers each prisoner to confess

• If their confession is necessary for conviction (because the other didn’t confess), they will be set free (and the other prisoner will serve the maximum 10 year sentence)

• If the confession is not necessary (because both confess), they will both be charged with robbery, but prosecutor will ask for a mitigated sentence (6 years) due to the confession

• If neither confesses, prosecutor will convict both for illegal gun possession (3 years)– The prisoners have no way to communicate. What will they decide?

Years in prison Confess Don’t

Confess 6,6 10,0

Don’t 0,10 3,3

Prisoner A

Prisoner B


RivalryRivalry as a prisoner’s dilemma

• Same problem for competing firms– If firm A charges a high price & firm B charges a low price,

customers will buy at firm B (firm A=no profit, firm B=$5M profit)– If both firms price low, they both make low profits ($1M)– If both firms price high, they each earn high profits but split the market between them ($3M)– If firms have no way to communicate, they will both price low– Lowering prices is a form of confrontation (strategic action that requires harming rivals)

• Rivalry is the degree to which rivals are likely to engage in confrontation

• Assessed by comparing rivals’ propensity for confrontation with their propensity for pursing other strategic actions– Differentiation: making your product less substitutable with rivals’ products

(through branding, quality variations)– Coordination: acting jointly with rivals to maximize joint benefit

$M profit Price low Price highPrice low 1,1 0,5Price high 5,0 3,3


RivalryPropensity for confrontation

• Propensity for confrontation is best measured firm by firm, by looking for mavericks: firms that are unhappy with the status quo & are able to change it– Firms with an advantage in confronting rivals– Firms who are within reach of a significant competitive advantage

• Common characteristics of mavericks– Firm with low barriers to expansion (cheap & quick to expand production;

sometimes called “scalable business”)• Barriers to expansion discussed in next slide

– Firm that can impose BTEs on rivals (deny rivals economies of scale/scope, deny rivals access to complements, orchestrate regulation that excludes rivals)

• E.g., firm with deeper pockets (when access to financial markets is limited)– Firm with much lower cost structure (can win price war)

• Same for firm with much greater network effects (can win standards war)– Firm under (but in reach of) MES, when reaching MES give significant advantage


Propensity for confrontationBarriers to expansion

• Ratio of fixed costs to variable costs– Easier to expand when ratio is high (i.e., most costs are FC), because expanded

production lowers ATC– Example (differences in technology): easier to expand production of internet-

downloaded music than CD-based music; easier to expand satellite TV service than cable TV service

– Example (differences in capacity): easier to expand for firm with excess capacity (higher FC/VC ratio) than for rivals who operate at full capacity

• Product homogeneity– Easier to expand in a homogeneous market than in a heterogeneous one (in

latter, a marketing problem: some customers prefer rivals’ product)– E.g., easier to expand in selling salt (homogenous) than music (heterogeneous)

• Access to distribution channels– Lack of distribution channels limits ability to expand


Propensity for confrontationPotential competition

• When analyzing propensity for confrontation, consider not only existing rivals, but also potential competitors: firms making (or expected to make) products that are likely to be part of the market due to expected substitution changes or expected erosion of BTEs into the market

• Expected substitution changes can result from:– Changes in customer preferences– Entry/exit of products– Rebranding/repositioning of products– New technologies


RivalryIncentive: propensity for differentiation

• Differentiation: reduces substitution with rivals by exploiting an advantage over rivals in a basis of competition

• Market’s propensity for differentiation depends on:– Bases of competition (other than price) firms can use to differentiate– Trade-offs between bases of competition (e.g., prestige will be negatively

affected if price is lowered)– Capacity constraints (tight constraints = less benefit from appealing to entire market)

• Differentiation is a double-edged sword– Reduces need for coordination (confrontation is less likely)

• Firms can increase prices >MC, since their products are imperfect substitutes– But increases cost of coordination (harder to fix prices)

• More difficult to detect deviations in quality/price


RivalryIncentive: propensity for coordination

What does a cartel do?

• Martin, This spud’s not for you, WSJ– United Potato Growers of America (UPGA) is a co-op that acts as a cartel of

potato growers (legal under an exemption to US antitrust rules)• Julia Cissel, CEO of UPGA: “We’re helping people get the message of,

‘Stop overproducing’”• What does she mean by “overproducing” - how much is the “correct”

amount to produce?


113 6

Supply Curve

Price

5

11

8

Demand Curve (P=11-

Q)

“Overproduction”


Propensity for coordinationWhat does a cartel do?

• “UPGA … is trying to preserve the North American potato farm”• The trend

– Under 10K farms today; 30 years ago: 50K• Causes

– “That’s partly because… big growers are gobbling up small ones…”• Why are small growers being gobbled up?

– “Potatoes remain the most popular individual accompaniment to a main dish, but people are cooking fewer at home.”

• Assume total amount of potatoes consumed remains same, but more are consumed in fast food chains, fewer at home. Effect on the small farm?

• Note impact of distribution channels on MES• “In years past, potato farmers were all too willing to take a loss on

sales if it meant increasing their market share. The result was that prices became so low, the industry was unprofitable.”– Why are farmers willing to sell at a loss?



• How is UPGA responding to this trend?– Cartels are a form of coordination that allows firms to raise their prices, but it

doesn’t necessarily improve production efficiency or add value– If the problem was due to MES & production costs, how does a cartel preserve

the small potato farm?• How is UPGA responding to this trend? (UPGA’s plan)

– “The Idaho co-op hired Jerry Wright… to handle business decisions. He pushed the group to go national. Although Idaho produces around 30% of U.S. potatoes, Mr. Wright believed the co-op couldn’t influence prices without members from other big potato states.”

– How does UPGA plan to influence prices?– Why won’t that work if they only have a 30% market share?



• How is UPGA responding to this trend? (Process)– Determine optimal size of the cartel (e.g., > Idaho)

• Why not go for 100% market share?– Determine optimal (monopoly) price & quantity– Divide quantity into member production quotas– Monitor compliance

• UPGA uses satellite photography & GPS– Punish violators

• Fines up to $100/acre



• Cartels require enforcement (detection & punishment) mechanisms because the prisoner’s dilemma still exists in the background– “Some skeptical nonmembers [of UPGA] think the co-op is merely a way to help

large Idaho farmers who typically have overproduced… Tim Hobbs of the Maine Potato Board[:] ‘If the problem was caused in the West, the West ought to solve the problem.”

– For Maine potato growers, what’s the best scenario?

– Not join UPGA, but UPGA succeeds– Join UPGA, UPGA succeeds– Not join UPGA, UPGA fails– Join UPGA, but UPGA fails



P Q

• Why is it so difficult?– “[F]armers of fresh vegetables have tended to avoid co-ops due to market

volatility, varying regional tastes and quality-control concerns stemming from climate differences. Potato farmers have proven especially resistant to joining national groups, partly because different growers serve different customers.”

• (Processed) food companies: fixed production levels & prices• Grocery stores/open market sales: prices fluctuate

• How does each of these make coordination harder?– Cartel’s market share– Market volatility (stability of market demand)– Differentiation

• Differentiated goods (because of varying regional tastes & climate differences)• Differentiated customers (customers with different bases of competition)

– Entry (if cartel succeeds & prices are high, new firms will try to enter)



Propensity for coordinationAnalyzing propensity to coordinate

• Before Stigler (1964), coordination was seen to be determined by market concentration– E.g., coordination is more likely with 3 firms that each have 33% market share

than with 100 firms 1% each• Structure-Conduct-Performance (S-C-P) school of industry analysis

– Industry structure (mainly market concentration), affects -– Individual firms’ conduct (price close to monopoly price or close to MC), which

affects –– Firms’ performance (high or low profitability)


Analyzing propensity to coordinateMeasuring market shares

Why does market share indicate possession of MP?

• Scenario 1: Acme has a 90% market share– Acme produces 90 widgets in a market that demands 100 widgets– Two more firms produce 5 widgets each

• Acme tries to act like a monopolist– Acme reduces its production by 20 widgets, to 70– Total market output is 80 while demand is 100, so prices go up– If nothing changes, Acme captures 87.5% (70/80) of monopoly profits

• Rivals’ try to fill void– Rivals try to raise their output by 10 widgets each (200% increase)– Need to triple their factories, work force, purchases, etc.– Would cost a lot & take time



• Scenario 2: Acme has a 50% market share– Acme produced only 50 widgets in the same market– 5 other firms producing 10 widgets each

• Acme tries to act like a monopolist– Reduces its output by 20, to 30 widgets– If nothing changes, Acme captures 37.5% (30/80) of monopoly profits

• So Acme likely to make a lower cut in production (less MP)• Rivals try to fill void

– Each rival needs to produce 4 more widgets (40% increase)– Quicker & cheaper to do than a 200% increase



• Criteria that reduce reliability of market shares as indicators of MP– Low barriers to expansion– Low BTEs– Significant buyer/supplier power– Highly fluctuating market shares

• Units: market share of what?– Detailed discussion in: Gregory J. Werden, Assigning Market Shares, 70

Antitrust L.J. 67 (2002)– Normally, market share is measured by $ revenue, but sometimes another

figure needs to be used



• Units: when revenue info is difficult to get– Find a proxy that is correlated to revenues or that reflect the ability to create a

price-raising shortage in the market– Examples students used in past reports

• Capacity of airport shuttles• Amount of X-ray liquids purchased by chiropractors

• Units: when product is free– E.g., mobile phone operating systems: what units would you measure for MS?– E.g., search engines: what units would you measure for MS?

• Units: when products in market vary widely in price– E.g., food wrapping materials market includes aluminum foil & plastic wrap

• Aluminum foil costs $2.84 for 75 ft²; plastic wrap costs $1.13 for 100 ft² (85¢ for 75 ft²)– Company A sells 75M ft² of plastic wrap (revenue: $850,000)– Company B sells 75M ft² of aluminum foil (revenue: $2.84M)– Market shares by revenue: A – 23%; B – 77%– Does this reflect their relative MP? What would you use instead?


Analyzing propensity to coordinateMeasuring concentration

• Concentration combines two issues1. How much market share is needed to restrict output?

• Often, assumption is that you need a market share of at least 60-80%2. Size of coalition: how many firms must coordinate to have this market share?

• Often assumption is coordination of more than 4 firms is difficult to sustain• Older method: CX

– Example: jarred baby food market• 2-firm concentration ratio (C2) = 65+17.4 = 82.4%• 3-firm concentration ratio (C3) = 65+17.4 + 15.4 = 97.8%

– Four-firm ratio (C4) is commonly used

• Problem with CX

• {25%, 25%, 25%, 25%}• {49%, 49%, 1%, 1%}• What is the C4 in each market?• Is coordination easier in one of these markets than the other?

Market share (%)Gerber 65Heinz 17.4Beech-Nut 15.4


• Newer method: Herfindahl-Hirschman Index (HHI)– Instead of simple adding market shares, square the market shares and then

add them– {25%, 25%, 25%, 25%}: 25² + 25² + 25² + 25² = 4 x 625 = 2,500– {49%, 49%, 1%, 1%}: 49² + 49² + 1² + 1² = 2401 + 2401 + 1 + 1 = 4,804– Why is this better than CX?

• Example: jarred baby food– 2.2% not accounted for in the data we have

• We assume it was produced by a single firm• Will it cause HHI to overstate or understate

concentration?• Will it make a big difference?

– The higher the HHI, the easier it is for firms to coordinate– HHI is most meaningful when examined in same market over time

Analyzing propensity to coordinateMeasuring concentration


Share S2

Gerber 65 4225Heinz 17.4 302.76Beech-Nut 15.4 237.16Other 2.2 4.84Total 100% 4769.76

Analyzing propensity to coordinateMergers & concentration

• A merger or joint venture of rivals increases concentration• To assess the effect on concentration (and therefore on market’s

propensity to coordinate after the merger), we should consider:– HHI after the merger– Change in HHI due to the merger? (Delta (∆))

• Example: Jarred baby food– Heinz & Beech-Nut merge– Post-merger HHI: 5305.68– Delta (∆): 535.92 (5,305.68-4,769.76)

• Quick way to find ∆ in a 2-firm merger– 2 x A’s share x B’s share– 2 x 17.4 x 15.4 = 535.92


Share S2

Gerber 65 4225Heinz 17.4 302.76Beech-Nut 15.4 237.16Other 2.2 4.84Total 100% 4769.76

Pre-merger

Share S2

Gerber 65 4225

H + BN 32.8 1075.84

Other 2.2 4.84

Total 100% 5305.68

Post-merger


• But concentration isn’t everything– Industries with similar concentration exhibit different levels of coordination

• Stigler, A theory of oligopoly (1964) points out that colluding, like other economic activities, depends on cost-benefit analysis

• Benefits to firms from coordination depend on:– Self-elasticity of demand (more elastic = less gain from coordination, because

customers reduce demand more when price rises)– BTE (low BTE = less gain from coordination; entrants will undercut prices)

• Costs– Agreeing on terms (and renegotiating them)

• More difficult when member firms have different incentives• More difficult when market widely fluctuates (renegotiation)

– Detecting cheating• If they can’t directly observe rivals’ prices or outputs, firms deduce them from deviations in

their own expected sales, but “noise” (randomness in costs & demand) makes this difficult– Punishing deviation (potential for successful confrontation)

• Rivals punish deviation by refusing to coordinate with a “cheater” in the future• Better if cartel can deny the “cheater” some other benefits



• Stigler’s effect on analysis: shifted focus from market concentration to coordination-facilitating conditions– Reducing cost/increasing probability of detection

• Joint sales operations• Information sharing & “match our rivals’ prices” promises• Standardizing products to make cheating more transparent

– Reducing cost/increasing severity of punishment• Joint operations (e.g., joint purchasing/sales)• Signaling of “non-aggressive” price cuts

– Increasing benefits of cartel• High BTE• Low elasticity of demand



• Dick, When are cartels stable contracts? (1996), examined Webb-Pomerene Act cartels. Findings:

• Literature overstates cartel longevity, likelihood of reformation & propensity to learn from experience– Likelihood of reformation depends on anticipation of future government assistance– Firms that rely on private enforcement of cartels rarely make more than a

single attempt to collude– Many cartels created to cut costs (reach MES), not raise prices

• Variation in longevity explained by differences in the private costs & benefits of the cartels (confirming Stigler’s views)– Main factors: stability of market demand, product standardization, customer

size, cartel’s market share– Cartels become less stable as they age & as they make repeated attempts to collude– Common sales agencies increase cartel longevity; emphasizing price-fixing

destabilizes cartels© Amitai Aviram. All rights reserved.105

Propensity for coordinationIs coordination good or bad for society?

Good• Coordination can improve production efficiency & add value

– E.g., adopting an industry-wide standard; sharing fixed costs that aren’t fully utilized by individual firms (e.g., R&D, distribution facilities)

• Coordination can reduce volatility in price/production– But it is difficult to coordinate in markets with volatile demand– So, refining this point: coordination can reduce market cyclicity caused by

volatile supply, but tends to collapse if cyclicity is caused by volatile demand



Bad (economic reasons)• Coordination increases firms’ market power

– Firms may try to restrict output & raise prices– Even if they don’t explicitly attempt this, coordination can have

competition-reducing effects (reduced rivalry, increased BTE)– Social impact of increased MP

• Dead weight loss: loss of value to potential customers who buyproduct @ competitive price, but don’t buy @ monopolistic price

– Loss to customers & no gain to firm, so net loss to society– Higher demand elasticity → higher DWL

• Wealth distribution: customers who do buy at higher price lose the portion of the value they would have received if prices were lower

– Gain to firm equals loss to customers – is society worse off?• Reduction in innovation• Reduction in choice



Bad (political reasons)• Coordination increases firms’ political power

– But will government want to bust firm’s power? Government has dual, competing needs from firms:

• Wants firms not to be powerful enough to ignore/thwart government• But wants firms to be powerful enough to be co-opted to serve the

government’s goals; small, uncoordinated firms in competitivemarkets can’t:

– Change industry policy– Invest money in a social cause in lieu of government spending– Contribute to politicians’ campaigns

– So, government is likely to want firms to have enough political & market power to be useful to government, but not so much that they pose a threat to government’s authority


a) Economics of competitionb) Substitutionc) Entryd) Rivalrye) Supply chain

– Buyer/supplier market power– Price discrimination– Asset specificity– Multi-sided platforms



• Supply chain: Series of markets that together transform raw materials into finished products delivered to consumers

• Upstream markets (in relation to a particular link of the supply chain): markets that create raw materials for the particular link

• Downstream markets: markets that use the product of particular link

ProducingRaw materials

DistributingRaw materials

Transforming RM to goods

Distributinggoods Consumer

Upstream Downstream

Drillingfor oil

Shipping oil to refineries

Refining oil into gasoline

Gasstation

Car Owner


Supply chainWhat is a supply chain?

Supply chainBuyer & supplier MP

• Supply chains are important to the competition analysis because the value pool (the source of firms’ profits) of the entire supply chain is a single pool that is divided between the links (markets) of the supply chain

• Value pool (value to consumer – total supply chain costs) is divided according to relative competitiveness of markets

– Market’s competitiveness depends on substitution, entry, rivalry– The “unique” activity in the supply chain (very low competition) gets the

largest portion of the profits– The “commodity” activity (very high competition) gets almost no profits



• Example: To simplify, suppose that only use for crude oil is gas. Car owners would pay up to $3/gallon for gas; cost of drilling, transporting & refining: $2/gallon. Total gas sales: 100B gallons– How will the value pool ($100B) be appropriated?– Suppose oil extraction is monopolized, while competition in transporting,

refining, retailing & purchasing gas is very fierce– Result: The extraction market will appropriate most of the value from the VP at

the expense of the transporting, refining & retailing markets

Drilling for oil (extraction)

Transporting oil to refineries

Refining oil into gasoline

Gas station (retailing)

Car owner



• To assess buyer & supplier MP– Conduct a brief evaluation of substitution, entry & rivalry for each link of the

supply chain– If this “quick look” suggests significant MP, conduct a more thorough evaluation

of that link & look for evidence of exercising MP

• Buyer/supplier power when your firm also has MP (stacked monopolies)– When both a firm & its buyer or supplier have MP, each firm reduces output to

maximize price under the assumption that the other firm will do the same• E.g., monopolist oil company & monopolist refinery: refinery will buy assume

oil costs a monopoly price (pushing gas prices up), then it will further raise gas price to get monopoly profits on gas

– Result is bad for both firms: higher price & less output than if a single monopoly operated both drilling & refining activities

– Coordination of the two firms would increase output & decrease price (from stacked monopoly price to single monopoly price)


Supply chainBuyer & supplier MP: Price sensitivity

• Competition analysis (substitution, entry & rivalry) indicates a buyer’s/supplier’s ability to get a better price (by acting like a monopolist)– However, there are costs involved in acting like a monopolist, so the use of MP

also depends on its incentive (i.e., how much does it care to get a better price?)• This is measured by a buyer’s/supplier’s price sensitivity

– In the case of your customers (buyer power), this is the self-elasticity of demand in your market (less price-sensitive = less MP concern)

• Price sensitivity is often a matter of how significant the price of your component is to the other party’s profitability– E.g., if you create a $5 chip in a $500 tablet, doubling your price (100%

increase) only adds 1% to the tablet’s cost – might not be a priority for the tablet manufacturer to lower your price

• Framing is sometimes used to reduce price sensitivity– E.g., selling a product as an add-on to a much more expensive product


Supply chainPrice discrimination

• Price discrimination is a way to extract more of the VP (at customers’ expense) than a firm that sells @ monopoly price– So, supply chain analysis needs to

consider your ability to price discriminate(reduces buyer power) & suppliers’ability to price discriminate against you(increases supplier power)

• Recall our analysis of a monopoly– Why doesn’t the monopolist sell to

customers in the red triangle?(those willing to pay >$5 but less than $8)

– Price discrimination is a way to sell tothose customers without losingrevenue from customers who arewilling to pay >$8

Price

Quantity

5

11

113 6

8Produc

er Surplus

Total Cost

Cons. Surplus


Supply chainPrice discrimination

• Firm divides customers into 2 groups– Cheapskates: those who value widgets

more than $6 but less than $8– Suckers: those who value its widgets

at or above $8• Sells 3 units @$8 to the suckers• Sells 2 units @$6 to the cheapskates• TR = $36 ($24 + $12)• Cost = $28 ($5 x 5 units +$3 overhead)• Profit = $8

– Compared to $6 with a single price• Problems with this plan?

Price

Quantity

5

11

113 6

8

6

5


Supply chainPrice discrimination - conditions

• Prefect price discrimination requires:– Ability to costlessly determine the value of the product to each

customer– Inability of customers to acquire the product elsewhere

• No competition• Inability of customers to resell

– Positioning (reputation, brand)– Legally permissible


Supply chainPrice discrimination: how?

• Discriminating by customer efforts– Coupons

• Discriminating by time– Hardcover books before paperbacks– First-run / second-run movies, delayed release to DVD

• Discriminating by extra features– “Limited edition” DVDs or computer games

• Discriminating by measuring use– Bundling (variable proportions)

• Discriminating by value averaging– Bundling (fixed/no proportions)



Bundling (variable proportion products)• Example: Printer & toner: heavy users use more toner than

light users– Who is likely to value a printer more?– Costs

• Printer $100; Toner $1; Toner can print 1,000 pages– Value to customers: 1¢ of per printed page

• Customer A will print 20,000 pages (20 toners). Value: $200• Customer B will print 30,000 pages (30 toners). Value: $300



Bundling (variable proportion products)• Price printer @ cost & toner @ highest possible price

– A will pay up to $200: $100 for printer & $100 for toner ($5 ea.)– B will pay up to $300: $100 for printer & $200 for toner ($6.67 ea.)

• Firm’s options– Toner @ $5 (sell 50): Profit $200 (50x$5)-(50x$1)– Toner @ $6.67 (sell 30): Profit $170 (30x$6.67)-(30x$1)

• Why do firms typically bundle toner rather than paper?



Bundling (variable proportion products)

• Another example: Popcorn in movies



Bundling (fixed/no proportion products)• Firm sells two movies: When Harry Met Sally (Romantic

comedy) & Spaceballs (Sci-Fi comedy)– Each DVD costs $5 to produce

• Value to Customers– Romantics value WHMS @$10 & Spaceballs @$6– Sci-Fi fans value Spaceballs @$10, and WHMS @$6– Assume market includes one romantic & one sci-fi fan



Bundling (fixed/no proportion products)• Firm sells the movies separately

– Prices each movie @$6• Firm sells 4 movies (2/customer); profit: $4 [(4x$6)-(4x$5)]

– Prices each movie @$10• Firm sells 2 movies (1/customer); profit: $10 [(2x$10)-(2x$5)]

• Firm bundles, sells combo @$16– Firm sells 2 bundles; profit: $12 [(2x$16)-(2x$10)]


Supply chainAsset specificity

When is opportunism most likely?• Hypo: a newspaper hires a lawyer to review a lease. The

market for lawyers is competitive, with a dozen lawyers willing to do the job for $200

• After signing a contract with lawyer A, he holds out & demands $300 or he won’t do the job– Is the newspaper likely to concede to A’s demand?

• What if the market is not competitive at all - A isthe only lawyer available who can do this job(i.e., no substitution, entry & rivalry)?



• The newspaper also determines that it doesn’t have a competitive advantage in printing, so it wants to outsource its printing functions

• To meet tight deadlines, the printer’s machines must be connected to the editorial board’s computers– This costs $10M– The $10M are lost if the newspaper stops

working with that specific printer• The printing market is competitive, with a

dozen printers willing to work for $200/day



• The newspaper signs a contract with printer C, at a price of $200/day

• After the newspaper spends $10M to connect its computers with Printer C’s system, Printer C refuses to honor the agreement unless the price is raised to $300/day.– Buyer/supplier power reflects the risk of

opportunism by buyers or suppliers• Is the newspaper likely to concede to C’s

demand?– Note that the printing market is competitive – is it

the same as the original law firm situation?



• Compare the following scenarios:– A Burger King franchisor hires a new burger-flipper. After a

year on the job, the employee demands a big raise, or he’ll quit.– Goldman Sachs hires a stock trader. After a year on the job, the

employee demands a big raise, or she’ll quit.– Warner Brothers hire Daniel Radcliffe to play Harry Potter in the first of

seven planned movies. After the debut of the first move, Daniel demands a big raise, or he won’t play in the future movies.

• In which of these is the employer most likely to give a raise?



• Williamson noted that the risk of opportunism depended on asset specificity (the lost value if an asset is deployed in another business)– Asset specificity increases as more relationship-specific

investment is needed to unlock its value• Party that has less relationship-specific investment

may act opportunistically• What’s the asset specificity (the relationship-

specific investment) in each case:– Burger King & the burger-flipper– Goldman Sachs & the stock trader– Warner Brothers & Daniel Radcliffe

Oliver Williamson


Supply chainAsset specificity - Types

1. Site specificity– E.g., transporting coal is expensive, so coal power plant is best located near a

coal mine– Result: plant is vulnerable to coal mine raising prices

2. Physical asset specificity– Cars can be made to run on gas or diesel, but it is expensive to switch from one

to the other– Result: drivers are vulnerable to gas/diesel prices going up

3. Dedicated assets– Assets made specifically for particular user, that would have otherwise not

been made (e.g., custom-tailored clothes)– Result: once made, customer can renegotiate under threat of reneging


Supply chainAsset specificity - Types

4. Human asset specificity– Development in human capital (learning, team building) that is lost if individual

shifts to another job5. Intangible assets

– E.g., reputation, brand name6. Temporal specificity

– Timing of product is crucial, so delay would lose much of its value– E.g., if newspaper/sports broadcast comes out a day late, it is worthless– Result: threat of a delay can be used to renegotiate better deal


Supply chainMulti-sided platforms

• Multi-sided platforms are products that allow direct interaction between 2 or more types of customers– E.g., credit cards (shoppers <-> merchants); newspapers (readers <-> advertisers)

• Rivalry in MSPs– Confrontation between MSP participants is more beneficial to stronger parties

(excluding smaller participants from the MSP can eliminate or greatly weaken them)– Coordination between MSP participants is harder to detect: easy to mask

coordination as necessary communications– Both confrontation & coordination between MSPs are more likely while the

MSPs operate below MES• A race to consolidate & become the largest MSP

– Confrontation between MSPs more likely & coordination less likely when one MSP reached MES and the other has not (small MSPs want to interconnect with larger ones; large MSPs try to resist this)

• Large MSPs want to protect their market dominance• Large MSPs want to recoup cost of developing their network


business strategy for lawyers chapter 2: the strategic environment (competition) prof. amitai aviram...

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