Business Strategy for Lawyers - PowerPoint Presentation

433 views
Uploaded On 2015-11-11

Business Strategy for Lawyers - PPT Presentation

Chapter 2 The strategic environment competition Prof Amitai Aviram Aviramillinoisedu University of Illinois College of Law Copyright Amitai Aviram All Rights Reserved S14D The strategic environment competition ID: 189915

aviram amp reserved amitai amp aviram amitai reserved rights price market demand supply elasticity firm firms costs product cost prices economics propensity

Link:

Copy

Embed:

<iframe width="560" height="315" src="https://www.docslides.com/embed/189915" frameborder="0" allowfullscreen></iframe>

Download Presentation from below link

Download Presentation The PPT/PDF document "Business Strategy for Lawyers" is the property of its rightful owner. Permission is granted to download and print the materials on this web site for personal, non-commercial use only, and to display it on your personal computer provided you do not modify the materials and that you retain all copyright notices contained in the materials. By downloading content from our website, you accept the terms of this agreement.

Presentation Transcript

Slide1

Business Strategy for LawyersChapter 2:The strategic environment (competition)

Prof. Amitai Aviram

Aviram@illinois.edu

University of Illinois College of Law

S14DSlide2

The strategic environment (competition)Overview of Chapter 2Economics of competitionStatic analysis: supply & demand curves

Dynamic analysis: changes in supply & demand

Market power & constraints on pricing

SubstitutionEntryRivalrySupply chain

2Slide3

Economics of competitionWelcome to business hell…To understand competition, start in business hell:Perfect competition & marginal cost pricing

3Slide4

Economics of competitionThe concept of marginal costMarginal cost (MC): cost of producing the next unit of the productExample

Producing one widget requires 1 person to work for 1 hour to assemble it

Wage: $4/hour

Raw materials: another $1/widgetOverhead cost: $3, regardless of# of widgets produced (this couldbe rent, management costs, etc.)

Widgets Produced

Total Cost

Marginal Cost

2$13$53$18$54$23$55$28

4Slide5

Economics of competitionHow low can you price?You are a widget producer in a competitive marketTo get customers to buy your widgets, you must offer them the lowest price possibleOf course, you can’t offer a price

so low that you’ll be better off not

producing the widget

So, how low can you price?Widgets Produced

Total Cost

Marginal Cost

Economics of competitionHow high can you price?We now know how low a firm can sell its productBut 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 marketIn a perfectly competitive market, P=MCSuppose 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)

7Slide8

Economics of competitionThe supply curveThe supply curve shows the aggregate (market-wide) supplyof a product at a given priceI.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)

Quantity (Q)

Supply curve of our example (blue)

8Slide9

Economics of competitionThe supply curveBut in the real world:Different firms have different MCsMC 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 riseCosts rise as resources are overused, or less efficient resources are usedLowest-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)

Quantity (Q)

Typical “real world”

supply curve (gray)

9Slide10

Economics of competitionThe demand curveThe 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)

10Slide11

Economics of competitionMeasuring demandSelf-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-QA decrease of $1 in price increases demand by one unitAt 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)

Quantity (Q)

P=11-Q

(red)

11Slide12

Economics of competitionSelf-elasticity of demandOn one extreme is a perfectly elastic demand, such as P=5Ed

=-∞

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)

Quantity (Q)

Perfectly elastic demand (blue)

12Slide13

Economics of competitionSelf-elasticity of demandOn the other extreme is a perfectly inelastic demand, such as Q=6Ed

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)

Quantity (Q)

Perfectly inelastic demand (green)

13Slide14

Economics of competitionSelf-elasticity of demandSelf-elasticity is measured empiricallyHowever, major factors affecting it can be used as proxies (examples, reducing elasticity):No close substitute / product not commoditizedE.g., famous artist’s painting, books, movies

Necessary purchase

E.g., life-saving medicine

Price is not salient to customersE.g., restaurant menuPurchase quantity/bundle not fixedE.g., selling in smaller boxes instead of raising pricesHarder to compare prices & to notice price changes© Amitai Aviram. All rights reserved.

14Slide15

Economics of competitionSelf-elasticity of demandReal-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): -0.4Car 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)© Amitai Aviram. All rights reserved.15Slide16

Assume demand curve is: P=11-Q; supply curve is P=5In perfect competition, market priceis where supply & demand curvesintersect

(Here, at: P=$5, Q=6 units)

Market power (“MP”)

The ability of a firm (or group of firms) tocharge >MC (i.e., above supply curve)Another definition of MP: ability to affectmarket price or market outputThe more MP, the greater the firm’sfreedom to raise prices

Economics of competition

Intersecting supply & demand

Price (P)

Quantity (Q)

Supply curve (gray)

Even if firm has MP, it is constrained by the demand curve:higher P means lower QHere, 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)

Quantity (Q)

Supply curve (gray)

Economics of competitionDynamics: changes in demand

Price (P)

Quantity (Q)

Demand curve

Red: P=11-Q

More D - Green: P=13-Q

Less D - Blue: P=9-Q

54A demand increase (demand curve shifts to the right) means that the value customers receive from the product has increasedNote: cause of demand increase is separate from issue of product’s priceIf demand increases, quantity & prices riseLikewise, if demand decreases (value from product is reduced), both prices & quantity fall© Amitai Aviram. All rights reserved.18Slide19

Economics of competitionDynamics: changes in supply

Price (P)

Quantity (Q)

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 priceIf supply increases, quantity rises & price dropsLikewise, if supply decreases (less Q produced at a given MC), quantity falls & prices rise© Amitai Aviram. All rights reserved.19Slide20

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 pricesE.g., if P goes down, customer may use product for more things; if P goes up, producer may expand capacityBut 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

20Slide21

Economics of competitionDynamics: cyclical markets

Example: supply-driven cycle

Demand increases

E.g., new industry requires copperP rises & Q rises (high profitability)Producers expand capacityBuild/expand mines

Since new capacity takes yearsto 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

21Slide22

Economics of competitionDynamics: cyclical markets

Cycle continued

Profitability very low

Firms go bankrupt (some capacity lost)Other firms can’t afford to expand capacityExcess capacity disappearsDemand 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?

22Slide23

Economics of competitionDividing the value pool – No MPCustomer surplus is the value of the product to the customer less the price the customer paidWhen 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)

Quantity (Q)

Customer surplus

Supply curve (blue)

Total cost & total revenue

Economics of competitionDividing the value pool – With MP

Price (P)

Quantity (Q)

Customer surplus

Total cost

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 enjoySurplus from each purchased widget is $1 lower (because widgets cost $1 more)Total revenue is unchanged: $30Was 6x$5; now 5x$6But total costs lower ($30→$25)Because fewer widgets are producedRemaining $5 are the producer surplus (profits)© Amitai Aviram. All rights reserved.24Slide25

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 monopolistAssume 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 importingNo competition to undercut your prices!

Suppose that MC=$5

Should you charge $6? $6,000? $6M?

25Slide26

Economics of competitionValue as a pricing constraintGoodbye marginal cost pricing…Monopolist’s price cannot be undercut by competitorsTherefore, 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 bothHello 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

26Slide27

Economics of competitionMarginal revenue pricingExample: 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

(TR

Q+1-TRQ)Profit(T. Rev-T. Cost)1$5$8$10$10$8$22$5$13$9$18

$18

$24

$23

$28

$30

$33

$30

$-2

$-3

$38

$28

$-10

Total revenue is maximized when

marginal revenue = marginal cost

27Slide28

Economics of competitionSupply reduction & deadweight lossMonopolist 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 $8Would it be profitable to sell additional widgets to those customers?Why doesn’t the monopolist sell to them?

Price

Quantity

Producer Surplus

Economics of competitionMeasuring MPSo, 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?© Amitai Aviram. All rights reserved.

29Slide30

Economics of competitionMeasuring MPExample 1A significant cost in manufacturing widgets is the cost of oil, which fuels widget-producing machinesOil 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 2Springfield Nuclear Power Plant has alwaysbeen the only electric company in SpringfieldSNPP never raised its prices above the rateof inflation. Does this prove that SNPP hasno MP?

30Slide31

Economics of competitionMeasuring MPSince we usually can’t identify MP just by observing prices & output, we need a tool to identify whether a firm possesses MPThis tool is competition analysisCompetition 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

31Slide32

Economics of competitionThe forces that shape competitionIf the following assumptions were correct, a firm would have maximum MP:No substitution: customers can’t substitute to another product that responds to same needs

entry

: other firms can’t adjust to offer the productNo rivalry: firm is the only one offering the productNo buyer/supplier power: suppliers’ & customers’ markets are perfectly competitiveSince 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)

32Slide33

Economics of competitionSubstitutionCross elasticity of demandProxies for cross-elasticityRefining the substitution analysis

Entry

Rivalry

The strategic environment (competition)Overview of Chapter 2Slide34

Cross-elasticity of demandCompared to self-elasticitySubstitution is measured by assessing the cross-elasticity (“X-elasticity”) of demandSelf-elasticity: the degree in which a rise in the priceof Product A

decreases demand for

Product A

Affected by substitution (to all other products) & valueX-elasticity: the degree in which a rise in the price of Product A increases demand for Product BAffected by substitution to a specific product© Amitai Aviram. All rights reserved.

34Slide35

Cross-elasticity of demandExamplesHigh X-elasticity: Exxon gasoline & BP gasolineIf 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-dogsIncrease in the price of hot dogs will make some people opt for other foodsBut a consumer who decides a hot dog is too expensive is unlikely touse 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 DogsSlide36

Cross-elasticity of demandGeographic & temporal effectsX-elasticity is affected by functional distinctions, but also by geographical & temporal distinctionsGeographic distinctionsMcDonald’s in NE Urbana & Burger King in Savoy

Jewelry store in NE Urbana & jewelry store in Savoy

When does geography matter?

36Slide37

Cross-elasticity of demandWhy is it useful?

All beverages

Non-alcoholic beverages

Carbonated beverages

Beer

Water

Sprite

Coke

Pepsi

Cola beverages

37Slide38

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?

38Slide39

Cross-elasticity of demandUsing cross-elasticityHow 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 MPSo, 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)

39Slide40

Cross-elasticity of demandUsing cross-elasticity: exampleAlso 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 profitableConclusion: Pepsi is in the market

Assumptions

Coke

Pepsi

Sprite

Beer

Sales ($)

100

Cross-elasticity of demandUsing cross-elasticity: exampleRound 2: Is Sprite in the market?Coke & Pepsi price up 5%; lost sales: $15Losses 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

Assumptions

Coke

Pepsi

Sprite

Beer

Sales ($)

100

Cross-elasticity of demandUsing cross-elasticity: exampleRound 3: Is Beer in the market?Coke, Pepsi & Sprite price up 5%; lost sales: $10Losses 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

Assumptions

Coke

Pepsi

Sprite

Beer

Sales ($)

100

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 SSNIPYou can replace that figure with whatever level of MP

you are interested/concerned about

E.g., if you want to check what market needs to be

Cross-elasticity of demandThe cellophane fallacyWe 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 unprofitableIf we look at x-elasticity at this point, would we say that Beer is in the same market as Coke, Pepsi & Sprite?© Amitai Aviram. All rights reserved.44Slide45

Cross-elasticity of demandThe cellophane fallacyCalled “cellophane fallacy” because it came up in an antitrust case (U.S. v. duPont), that dealt with cellophaneSolution 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 marketIf 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)© Amitai Aviram. All rights reserved.45Slide46

Economics of competitionSubstitutionCross elasticity of demandProxies for measuring substitutionRefining the substitution analysis

Entry

Rivalry

The strategic environment (competition)Overview of Chapter 2Slide47

Proxies for substitutionTools other than cross-elasticity?The advantage of X-elasticity as a market definition tool is that it can be empirically measuredDisadvantages 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)

Proxies for substitutionBaker, Market definition: an analytical overviewEvidence of past buyer response to price changeBuyer surveys (of their expected response to price change)

Product/geography characteristics that matter to buyers

E.g., shipping costs & geographical distribution of buyers

This is similar to our concept of customer benchmarksConduct of (supply-side) market participantsE.g., extent to which firms track & respond to price changes or product introductions of rivalsViews of market experts

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

48Slide49

Proxies for substitutionBrown Shoe Co. v. U.S.Intended to detect a sub-market in a larger marketIndustry recognitionSimilar to Baker’s points 4 & 5

Product’s characteristics & uses

Similar to Baker’s point 3

Unique production facilitiesWhat prevents manufacturer of product A from producing B?Essentially tracks supply substitution (entry)Distinct customers

Sensitivity to price changesSimilar to Baker’s points 1&2

Specialized vendors

49Slide50

Proxies for substitutionGeroski & Porter Geroski, Thinking creatively about your marketDefines market as viable ways to satisfy a need

Need + economic viability replace direct proxies for buyer substitution

Identify a need

Figure out how the need can be supplied (i.e., how a product can satisfy customer benchmarks)Is this a viable activity?Consider demand, rivals, substitutes, etc.Identify strategic necessity (minimum viable scale/scope)

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

50Slide51

Proxies for substitutionSummaryDirect 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 qualityCustomer benchmarks (from basis of competition analysis)

Producer behavior (who do they track & respond to?)

But filter for producers’ PR incentives

Economics of competitionSubstitutionCross elasticity of demandProxies for measuring substitutionRefining the substitution analysis

Cluster markets

Switching costs

The strategic environment (competition)

Overview of Chapter 2Slide53

Refining substitution analysisCluster marketsAre 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)© Amitai Aviram. All rights reserved.

53Slide54

Refining substitution analysisCluster marketsAdvantage of using cluster marketSimplicity – if products almost always sold in a bundle, all products respond in same way, so we treat them as oneProblem 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

54Slide55

Refining substitution analysisSwitching costsExamplesGyms with childcare: Children get used to particular childcare service; insulates gym from competitive pressuresCellphone 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 productEntry: 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

55Slide56

Refining substitution analysisCurrent substitution threatOnce market is defined, identify the closest substitutes to your “starting point” productSome 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:

56Slide57

Refining substitution analysisMarket definition: reviewPepsico v. The Coca-Cola Co.: Pepsi’s market definition: fountain soda distributed by independent foodservice distributors (IFDs)

Is fountain soda a separate market from other soda?

Is soda distributed by IFDs a separate market from soda distributed via bottlers?

57Slide58

Refining substitution analysisMarket definition: reviewIs soda distributed by IFDs a separate market from soda distributed via bottlers? Court: noIFDs provide more value, but bottlers can compete by priceAre 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© Amitai Aviram. All rights reserved.58Slide59

SubstitutionTeam project: market definitionEach team should pick one establishment on campus that offers foodConduct research to define the market that centers on this establishmentE-mail your team report to me (1 e-mail per team)

Process of the project

Select a starting point (very narrow – one specific establishment)

Identify (based on evidence) the bases of competitionCustomer needs & customer benchmarksSubstitutesIdentify potential substitutesFind evidence regarding the degree of substitution with your starting pointConclusion: 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)

59Slide60

Economics of competitionSubstitutionEntryEconomies of scale & scope

Access to inputs & complements

Imposing disproportional costs

The strategic environment (competition)

Overview of Chapter 2Slide61

EntryTypes of BTEKey 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

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 produceE.g., raw materials, hourly wages for laborFixed costs (FC): costs that don’t vary w/quantity producedE.g., rent, administrative costsMarginal 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, unitsDoes 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

62Slide63

Economies of scale & scopeCommon causes of supply-side economiesHigh FC compared to VCFC can be spread over more units if production increasesExample: 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

Economies of scale & scopeExampleYou are a widget producer; market price for widgets is $6Producing 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 widgetRent 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?© Amitai Aviram. All rights reserved.

64Slide65

Economies of scale & scopeExample: add capacity constraintsIt is only windy 4 hours/dayThe rest of the day you can’t use your machinesFactory 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 widgetHow much is the AVC for manual production?With market price @$6, firm maximizes profits @ 20 widgetsAbove 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)

65Slide66

Economies of scale & scopeExample

66Slide67

Economies of scale & scopeImpact on entryMES impacts the feasibility of entry into a marketIf you can’t get your market share up to the MES, then you’ll have higher production costs than rivals & gradually lose sales to rivalsExample

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 widgetsAjax’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

67Slide68

Economies of scale & scopeImpact on entryAnalogy to climbing up a slippery slideSlide length: MES / entrant’s initial salesIf 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 @ MESWhen entrant reaches MES, this is 100%Amount in excess of 100% represents entrant’scost disadvantage compared to incumbent whoalready reached MES

How can a firm that operates below MES survive?

68Slide69

Economies of scale & scopeSurviving below MESFind 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 ChampaignNote: 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 costsDisplace 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)

Bring antitrust suit/regulatory action (confrontation)

69Slide70

Economies of scale & scopeSurviving below MESReach an understanding to respect each firm’s turf (coordination)May violate antitrust laws

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/confrontationCosts beyond MESCosts start rising when producing above the MES; when they exceed costs of firms producing below MES, a small firm can survive below MESExampleAssume total demand is 34

If Ajax sells 14, ATC=$5.71; Acme then produces 20 widgets, w/ATC=$5.50If 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

70Slide71

Economies of scale & scopeCosts beyond MESWhat happens to costs beyond MES affects market structureIf costs climb steeply beyond MES (as in hypo & red graph below), larger firms won’t grow much above MES; small firms capture nichesIf 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)

71Slide72

Economies of scale & scopeMES & number of rivalsNumber of firms in the market is influenced by the ratio: MES/total demandIf 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)

72Slide73

Economies of scale & scopeEconomies of scale in demand (NW effects)Until now we considered economies of scale in supplyEconomies 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 phoneExample 2: credit cardsIf more people carry a given credit card, more merchants will accept itIf more merchants accept a card, more people want to carry that cardEach additional cardholder benefits all existing cardholders & merchants affiliated with that credit card brand

73Slide74

Economies of scale & scopeEconomies of scale in demand (NW effects)Example 3: electric cars & charging stationsPresence of charging stations increases the value of owning an electric car; presence of additional electric cars increases profitability of a charging stationExamples 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 customersE.g., credit cards (shoppers <-> merchants); newspapers (readers <-> advertisers)Do these have network effects?© Amitai Aviram. All rights reserved.

Facsimiles

Online markets

Word Processors

Soda DispensersSlide75

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

75Slide76

Economies of scale & scopeEconomies of scopeEconomies of scope in supplyATC drops if several products produced by same firm/plantE.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 togetherExamples: one-stop shopping; buying car body & car engine from same firmBTE: lower value to product of entrant who doesn’t offer both productsProducer 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)© Amitai Aviram. All rights reserved.

76Slide77

EntryAccess to inputs & complementsInputs are raw materials/services required to produce a productComplements are products consumed together with other productsExample: 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 complementIf demand for A increased – C is likely a substituteInputs/complements include (non-exhaustive list):Distribution of a productCapital (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)

77Slide78

EntryAccess to inputs & complementsAccess to inputs & complements as a BTEControl 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 issueE.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)

78Slide79

EntryOther actions that impose disproportional costsActions that impose lower (or no) costs on one firm (F) than a rival firm (R) can deter R from entering a marketLegislation / government regulationE.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 objectLess 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 rivalsLitigationLitigation often imposes costs disproportionately on partiesOne side has greater discovery & trial costs

One side has more potential for PR harm from discovery & trialOne 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

79Slide80

EntryOther actions that impose disproportional costsRegulation (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 lobbyingIn 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

80Slide81

Economics of competitionSubstitutionEntryRivalry

Propensity for differentiation

Propensity for coordination

The strategic environment (competition)

Overview of Chapter 2Slide82

RivalryRivalry as a prisoner’s dilemmaTwo 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

RivalryRivalry as a prisoner’s dilemmaSame problem for competing firmsIf 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 lowLowering prices is a form of confrontation (strategic action that requires harming rivals)Rivalry is the degree to which rivals are likely to engage in confrontationAssessed 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 high

Price low

RivalryPropensity for confrontationPropensity for confrontation is best measured firm by firm, by looking for mavericks: firms that are unhappy with the status quo & are able to change itFirms with

an advantage in confronting rivals

Firms who are within reach of a significant competitive advantage

Common characteristics of mavericksFirm with low barriers to expansion (cheap & quick to expand production; sometimes called “scalable business”)Barriers to expansion discussed in next slideFirm 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

84Slide85

Propensity for confrontationBarriers to expansionRatio of fixed costs to variable costsEasier to expand when ratio is high (i.e., most costs are FC), because expanded production lowers ATCExample (differences in technology): easier to expand production of

internet-downloaded

music than CD-based music; easier to

expand satellite TV service than cable TV serviceExample (differences in capacity): easier to expand for firm with excess capacity (higher FC/VC ratio) than for rivals who operate at full capacityProduct homogeneityEasier 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

85Slide86

Propensity for confrontationPotential competitionWhen 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 marketExpected substitution changes can result from:Changes in customer preferencesEntry/exit of productsRebranding/repositioning of productsNew technologies

86Slide87

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 differentiateTrade-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 swordReduces 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

87Slide88

RivalryIncentive: propensity for coordinationWhat 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?© Amitai Aviram. All rights reserved.88Slide89

113

Supply Curve

Price

Demand Curve (P=11-Q)

“Overproduction”

Propensity for coordination

What does a cartel do?Slide90

“UPGA … is trying to preserve the North American potato farm”The trendUnder 10K farms today; 30 years ago: 50KCauses“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

Propensity for coordination

What does a cartel do?Slide91

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 valueIf 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?

Propensity for coordinationWhat does a cartel do?Slide92

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 & quantityDivide quantity into member production quotas

Monitor

compliance

Propensity for coordination

What does a cartel do?Slide93

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

Propensity for coordinationWhat does a cartel do?

QSlide94

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 & pricesGrocery stores/open market sales: prices fluctuateHow does each of these make coordination harder?Cartel’s market shareMarket volatility (stability of market demand)DifferentiationDifferentiated 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

enter)

Propensity for coordination

What does a cartel do?Slide95

Propensity for coordinationAnalyzing propensity to coordinateBefore Stigler (1964), coordination was seen to be determined by market concentrationE.g., coordination is more likely with 3 firms that each have 33% market share than with 100 firms 1% eachStructure-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)© Amitai Aviram. All rights reserved.

95Slide96

Analyzing propensity to coordinateMeasuring market sharesWhy 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 monopolistAcme reduces its production by 20 widgets, to 70Total market output is 80 while demand is 100, so prices go upIf nothing changes, Acme captures 87.5% (70/80) of monopoly profitsRivals’ try to fill voidRivals 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

96Slide97

Analyzing propensity to coordinateMeasuring market sharesScenario 2: Acme has a 50% market shareAcme 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 widgetsIf nothing changes, Acme captures 37.5% (30/80) of monopoly profitsSo Acme likely to make a lower cut in production (less MP)Rivals try to fill voidEach rival needs to produce 4 more widgets (40% increase)

Quicker & cheaper to do than a 200% increase

97Slide98

Analyzing propensity to coordinateMeasuring market sharesCriteria that reduce reliability of market shares as indicators of MPLow barriers to expansionLow 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© Amitai Aviram. All rights reserved.

98Slide99

Analyzing propensity to coordinateMeasuring market sharesUnits: when revenue info is difficult to getFind a proxy that is correlated to revenues or that reflect the ability to create a price-raising shortage in the marketExamples students used in past reports

Capacity of airport shuttles

Amount of X-ray liquids purchased by chiropractors

Units: when product is freeE.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 ft

²; plastic wrap costs $1.13 for 100

² (85¢ for 75

²)

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?© Amitai Aviram. All rights reserved.99Slide100

Analyzing propensity to coordinateMeasuring concentrationConcentration combines two issuesHow much market share is needed to restrict output?

Often, assumption is that you need a market share of at least 60-80%

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 sustainOlder method: CXExample: jarred baby food market2-firm concentration ratio (C2) = 65+17.4 = 82.4%

3-firm concentration ratio (C3) = 65+17.4 + 15.4 = 97.8%

Four-firm ratio (C

) is commonly used

Problem with C

{25%, 25%, 25%, 25%}

{49%, 49%, 1%, 1%}

What is the C

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 + 25

² +

² = 4 x 625 = 2,500{49%, 49%, 1%, 1%}: 49² + 49² + 1² + 1² = 2401 + 2401 + 1 + 1 = 4,804Why is this better than CX?Example: jarred baby food2.2% not accounted for in the data we have

We assume it was produced by a single firmWill 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 coordinate

Measuring concentration

101

ShareS2Gerber654225Heinz17.4302.76Beech-Nut15.4237.16Other2.24.84Total100%4769.76Slide102

Analyzing propensity to coordinateMergers & concentrationA merger or joint venture of rivals increases concentrationTo 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 foodHeinz & Beech-Nut mergePost-merger HHI: 5305.68Delta (∆): 535.92 (5,305.68-4,769.76)Quick way to find ∆ in a 2-firm merger2 x A’s share x B’s share

102

Gerber

4225

Heinz

17.4302.76Beech-Nut15.4237.16Other2.24.84Total100%4769.76Pre-mergerShare

Gerber

4225

H + BN

32.8

1075.84

Other

2.2

4.84

Total

100%

5305.68

Post-mergerSlide103

Propensity for coordinationAnalyzing propensity to coordinateBut concentration isn’t everythingIndustries with similar concentration exhibit different levels of coordinationStigler,

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)CostsAgreeing 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

103Slide104

Propensity for coordinationAnalyzing propensity to coordinateStigler’s effect on analysis: shifted focus from market concentration to coordination-facilitating conditionsReducing cost/increasing probability of detectionJoint sales operations

Information sharing & “match our rivals’ prices” promises

Standardizing products to make cheating more transparent

Reducing cost/increasing severity of punishmentJoint operations (e.g., joint purchasing/sales)Signaling of “non-aggressive” price cutsIncreasing benefits of cartelHigh BTELow elasticity of demand© Amitai Aviram. All rights reserved.

104Slide105

Propensity for coordinationAnalyzing propensity to coordinateDick, 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 colludeMany cartels created to cut costs (reach MES), not raise pricesVariation 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 shareCartels become less stable as they age & as they make repeated attempts to collude

Common sales agencies increase cartel longevity; emphasizing price-fixing destabilizes cartels

105Slide106

Propensity for coordinationIs coordination good or bad for society?GoodCoordination 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/productionBut it is difficult to coordinate in markets with volatile demandSo, refining this point: coordination can reduce market cyclicity caused by volatile supply, but tends to collapse if cyclicity is caused by volatile demand© Amitai Aviram. All rights reserved.

106Slide107

Propensity for coordinationIs coordination good or bad for society?Bad (economic reasons)Coordination increases firms’ market powerFirms 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 priceLoss to customers & no gain to firm, so net loss to societyHigher demand elasticity → higher DWLWealth distribution: customers who do buy at higher price lose the portion of the value they would have received if prices were lowerGain to firm equals loss to customers – is society worse off?

Reduction in innovation

Reduction in

choice

107Slide108

Propensity for coordinationIs coordination good or bad for society?Bad (political reasons)Coordination increases firms’ political powerBut 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 competitive

markets can’t:Change industry policyInvest money in a social cause in lieu of government spendingContribute to politicians’ campaignsSo, 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

108Slide109

Economics of competitionSubstitutionEntryRivalry

Supply chain

Buyer/supplier market power

109

The strategic environment (competition)

Overview of Chapter 2Slide110

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

(in relation to a particular link of the supply chain): markets that create

raw materials

for the particular linkDownstream markets: markets that use the product of particular link

Producing

Raw materials

Distributing

Raw materials

Transforming RM to goods

Distributing

goods

Consumer

Upstream

Supply chainBuyer & supplier MPSupply 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 chainValue 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 profitsThe “commodity” activity (very high competition) gets almost no profits© Amitai Aviram. All rights reserved.

111Slide112

Supply chainBuyer & supplier MPExample: 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 gallonsHow 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

112Slide113

Supply chainBuyer & supplier MPTo assess buyer & supplier MPConduct a brief evaluation of substitution, entry & rivalry for each link of the supply chainIf 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 sameE.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 gasResult is bad for both firms: higher price & less output than if a single monopoly operated both drilling & refining activitiesCoordination of the two firms would increase output & decrease price (from stacked monopoly price to single monopoly price)

113Slide114

Supply chainBuyer & supplier MP: Price sensitivityCompetition 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 sensitivityIn 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 profitabilityE.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 priceFraming is sometimes used to reduce price sensitivityE.g., selling a product as an add-on to a much more expensive product

114Slide115

Supply chainPrice discriminationPrice discrimination is a way to extract more of the VP (at customers’ expense) than a firm that sells @ monopoly priceSo, supply chain analysis needs toconsider your ability to price discriminate(reduces buyer power) & suppliers’

ability to price discriminate against you

(increases supplier power)

Recall our analysis of a monopolyWhy doesn’t the monopolist sell tocustomers 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 are

willing to pay >$8

Price

Quantity

Supply chainPrice discriminationFirm divides customers into 2 groupsCheapskates: those who value widgetsmore than $6 but less than $8Suckers: those who value its widgets

at or above $8

Sells 3 units @$8 to the suckers

Sells 2 units @$6 to the cheapskatesTR = $36 ($24 + $12)Cost = $28 ($5 x 5 units +$3 overhead)Profit = $8Compared to $6 with a single priceProblems with this plan?

Price

Quantity

Supply chainPrice discrimination - conditionsPrefect price discrimination requires:

Ability to

costlessly

determine the value of the product to each customerInability of customers to acquire the product elsewhereNo competitionInability of customers to resellPositioning (reputation, brand)Legally permissible© Amitai Aviram. All rights reserved.

117Slide118

Supply chainPrice discrimination: how?Discriminating by customer effortsCouponsDiscriminating by timeHardcover books before paperbacks

First-run / second-run movies, delayed release to DVD

Discriminating by extra features

“Limited edition” DVDs or computer gamesDiscriminating by measuring useBundling (variable proportions)Discriminating by value averagingBundling (fixed/no proportions)© Amitai Aviram. All rights reserved.

118Slide119

Supply chainPrice discrimination: how?Bundling (variable proportion products)Example: Printer & toner: heavy users use more toner than light usersWho 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 pageCustomer A will print 20,000 pages (20 toners). Value: $200Customer B will print 30,000 pages (30 toners). Value: $300© Amitai Aviram. All rights reserved.119Slide120

Supply chainPrice discrimination: how?Bundling (variable proportion products)Price printer @ cost & toner @ highest possible priceA 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?

120Slide121

Supply chainPrice discrimination: how?Bundling (variable proportion products)Another example: Popcorn in movies

121Slide122

Supply chainPrice discrimination: how?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

Supply chainPrice discrimination: how?Bundling (fixed/no proportion products)Firm sells the movies separatelyPrices each movie @$6

Firm sells 4 movies (2/customer); profit: $4 [(4x$6)-(4x$5)]

Prices each movie @$10

123Slide124

Supply chainAsset specificityWhen 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 $200After 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 is

124Slide125

Supply chainAsset specificityThe newspaper also determines that it doesn’t have a competitive advantage in printing, so it wants to outsource its printing functionsTo meet tight deadlines, the printer’s machines must be connected to the editorial board’s computersThis 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

Supply chainAsset specificityThe newspaper signs a contract with printer C, at a price of $200/dayAfter 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?

Supply chainAsset specificityCompare the following scenarios:A Burger King franchisor hires a new burger-flipper. After ayear 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?© Amitai Aviram. All rights reserved.

127Slide128

Supply chainAsset specificityWilliamson 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 valueParty 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 traderWarner Brothers & Daniel Radcliffe

Oliver Williamson

128Slide129

Supply chainAsset specificity - TypesSite specificityE.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

Physical asset specificity

Cars can be made to run on gas or diesel, but it is expensive to switch from one to the otherResult: drivers are vulnerable to gas/diesel prices going upDedicated assetsAssets 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

129Slide130

Supply chainAsset specificity - TypesHuman asset specificityDevelopment in human capital (learning, team building) that is lost if individual shifts to another job

Intangible assets

E.g., reputation, brand name

Temporal specificityTiming of product is crucial, so delay would lose much of its valueE.g., if newspaper/sports broadcast comes out a day late, it is worthlessResult: threat of a delay can be used to renegotiate better deal© Amitai Aviram. All rights reserved.

130Slide131

Supply chainMulti-sided platformsMulti-sided platforms are products that allow direct interaction between 2 or more types of customersE.g., credit cards (shoppers <-> merchants); newspapers

(readers <-> advertisers

)

Rivalry in MSPsConfrontation 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 communicationsBoth confrontation & coordination between MSPs are more likely while the MSPs operate below MESA 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

131